Founded in 1998 and based in Brisbane, CA, Cutera, Inc. (CUTR) designs, manufactures and markets laser and light-based aesthetic applications. Since it commenced commercial production in 2000, CUTR has quickly grown to become a leading player in the laser treatment category. Originally Altus Medical, the company changed its name to Cutera in January 2004 before going public in March 2004. Its flagship CoolGlide line of products is used in cosmetic processes such as permanent hair removal, and for treating pigmented lesions, wrinkles and veins. Cutera's primary customers are dermatologists and cosmetic surgeons, but it is also targeting its products for gynecologists and primary care physicians. The company derives revenue from four major sources: laser system sales (84% of 2006 revenues), upgrades (6%), service contracts (4%) and Titan refill revenues (6%). In the fourth quarter 2006, laser system sales were 85% of total revenues, upgrades 6% of revenues, service contracts 6% of revenues, and Titan refills were 3% of revenues.
While largely a discretionary consumer spending item given lack of 3rd party reimbursement, the market for aesthetic procedures has experiencing substantial growth with increasing interest in beauty treatments. Within this market, the non-surgical segment is growing the fastest. The aging Baby Boomer market is driving demand, and greater affluence makes the aesthetics market more accessible. The 35-64 age bracket represented, according to the American Society for Aesthetic Plastic Surgery (ASAPS) approximately 66% of 2006 U.S. procedures. As well, aesthetic procedures are becoming more acceptable in society. We estimate the aesthetic laser market is growing 10-20% annually. According to the ASAPS, $1.1 billion was spent in the U.S. in 2006 on laser skin treatments, roughly 25% of the $4.5 billion total of non-surgical cosmetic procedures. The entire U.S. surgical and non-surgical cosmetic market was approximately $12.2 billion in 2006. Since 2000, the U.S. laser skin treatment procedure market has grown 21% on a compounded annual growth basis.
Like many of its competitors, CUTR is expanding beyond the traditional dermatology market, attempting to attract family/general practitioners, gynecologists and other medical specialties like medi-spas and high-end beauty treatment centers. During the third quarter 2007 approximately 20% of CUTR's system sales came from traditional dermatologists and plastic surgeon specialties, while 32% of third quarter 2007 sales came from family practitioners, 5% from OB/GYNs, 13% from other physicians, and approximately 30% from medi-spa businesses. Our concern, despite solid historical growth, is that we believe much of the recent growth in the laser market can be attributed to the newer non-traditional market entrants. In particular, laser skin resurfacing procedures that can be performed by general practitioners, spas and beauty centers have grown 68% annually since 2002, while total non-surgical procedures have grown 22% annually (American Society for Aesthetic Plastic Surgery statistics). This newer market growth, although under penetrated, masks a slow down in more mature laser areas, like hair removal, and may not be sustainable. The previously fast growing laser hair removal market, the third largest non-surgical aesthetic U.S. market, only grew roughly 1% in 2006. We believe the company's first quarter 2007 revenue and EPS miss could be attributed to slower end markets along with poor results from a 2006 junior sales program, high senior sales turnover, and disappointing results with PSS and other national accounts. Second and third quarter 2007 revenues grew largely due to higher upgrade revenue, not product revenue, also suggesting slower end markets. Third quarter 2007 product revenues declined 6%, while product upgrades increased 217% (Pearl was launched worldwide in the quarter), service revenues increased 46%, and Titan refills increased 14%. However, international revenues increased 35% in the third quarter 2007, given product upgrades and relative market under-penetration.
The company is focused on research and development, which enables the consistent launching of new applications. Product innovations are the differentiating factors and key revenue drivers in the niche markets to which the company caters. Cutera rolled out Titan, an infrared light skin tightening treatment, which could create further growth opportunities. Titan was officially rolled out at the AAD (American Academy of Dermatology) meeting in February 2005. Titan is approved for topical healing in the U.S. and approved for wrinkles in Europe. The company launched two new Titan offerings, Titan V and Titan XL, in February 2006. The Titan V hand piece provides practitioners with enhanced visibility and 50% more pulses than the original Titan hand piece. The Titan XL hand piece enables faster treatment of large body areas, offering enhanced visibility with a treatment spot size that is twice as large as the Titan V. The skin tightening market is a substantial opportunity as an alternative to the lift-and-tuck cosmetic surgery market. While not a direct replacement for sagging abdominal, jowl, or upper arm skin, Cutera hopes to make inroads. Currently, an estimated 700,000 lift and tuck procedures are performed annually. Management expects faster revenue growth from this product line compared to its other product lines. The company continues to roll out new products. In October 2006, the company announced two new offerings, LimeLight and Navigation. LimeLight is the first programmable wavelength three-in-one device for skin rejuvenation, pigmented lesions and facial vascular lesions. It allows doctors the flexibility to customize treatments for their patients, resulting in better clinical results with fewer patient visits. The Navigation software provides practitioners with recommended operating parameters and storage of patient data on the Xeo platform. Pearl, a new wavelength laser for wrinkles, was cleared by the FDA in March 2007, and was launched during the second quarter 2007. In July 2007, the company also received the CE Mark approval for Pearl. The strong upgrade revenue growth in Q207 and Q307 (up 84% and 217% respectively) indicates strong initial acceptance of Pearl. Management's earlier belief was that Pearl, along with a larger and more experienced direct U.S. sales force, will allow Cutera to grow at least 20% in 2008, although as of Q307, the company is suspending forward financial guidance.
The company's strategy of offering upgradeable products provides additional leverage to its business model, helping it build the customer base necessary to sustain growth. The company's traditional market in dermatology and cosmetic surgery is relatively small, which makes competition more intense, particularly against more established competitors like Candela, Lumenis, Laserscope and Palomar. The company is expanding beyond the traditional dermatology market, attempting to attract family/general practitioners, gynecologists and other medical specialties like medi-spas and high-end beauty treatment centers. To further attract the non-core market with a lower price point, CUTR offers Solera, a lower-priced tabletop system that initially offered Titan for skin tightening. Solera Opus was launched as an expandable application tabletop system. The larger Xeo platform is also upgradeable and expandable for different applications.
Veins/ Vascular Lesions
Skin Tightening/ Fine Lines/Wrinkles
Solera Titan Infrared
Solera Opus IPL
XEO Platform (Infrared, IPL, Laser)
Coolglide Platform Nd:YAG Laser
Source: Company reports
To reduce side effect from unnecessarily heated skin, the company's cooling technology is applied through the handpiece. In the Coolglide family of products, the practitioner applies a thin layer of gel to allow the company s patented ClearView handpiece to glide across the skin. The practitioner next applies the ClearView handpiece, containing a temperature-controlled copper plate, directly to the skin to cool the area, and then delivers a laser pulse to the pre-cooled area. The Titan handpiece uses a sapphire cooling window and embedded temperature monitor. The temperature of the outer skin (epidermis) is controlled by using the sapphire window to provide cooling before, during and after the delivery of energy. The Titan handpiece is available on the Xeo and Solera families of products. The LimeLight 3-in-1 handpiece is used for the treatment of diffuse redness and facial telangiectasia. The LimeLight combines the benefits of three distinct light based devices into one unique solution with a wavelength range of 520-1100 nm. This range of wavelengths allows for both hemoglobin and melanin absorption. The ProWave 770 handpiece for hair removal allows selection of the appropriate wavelength. The ProWave 770's wavelength flexibility offers the best choices for all skin types. For instance, a shorter wavelength is preferred for lighter skin or fine, light hair. ProWave is available on the XEO and Coolglide platforms. The AcuTip 500 is the first light-based system to offer a targeted contact tip for tracing small vessels and is suitable for facial telangiectasia, freckles, pigmented lesions, and angiomas. The Pearl handpiece, introduced in second quarter 2007 and launched worldwide in Q307, utilizes YSGG laser technology and lightly ablates the skin, providing a stronger outcome than non-invasive light-based treatments with minimal patient downtime and discomfort. In cases where cooling is not needed, like treating pigmented lesions, other handpieces are used.
Its relationship with distributor PSS World Medical, with over 700 reps, should help the company penetrate the primary care market for laser treatments. Cutera's focus on sales expansion should also help, although results in 2007 have been lackluster. The company had about 47 direct sales territories/persons in North America at the end of 2005, an increase from 32 territories at year end 2004. At the end of 2006, the company had about 57 direct sales territories/persons in North America. The unsuccessful junior sales program and senior sales turnover affected territories in first quarter 2007 but the company discontinued the junior sales program and hired about 10 new senior salespersons in the quarter. The company ended third quarter 2007 with 64 sales territories in the U.S. and Canada, reaching the company's target for 2007. However, given the substantial turnover, the company had hired 33 sales reps (more than 50%) in the first three quarters of 2007. New hires take about 9 months to reach full productivity, so there will likely be some extended weakness through at least the fourth quarter 2007. Management will continue to employ experienced sales reps to re-accelerate its revenue growth. The company sells directly internationally to Japan (opening a second sales office in the third quarter 2007), Australia, France, Spain, the U.K., and Switzerland. CUTR uses distributors to sell to over 30 more countries. Hubs in Japan and Switzerland provide support.
Although Cutera has been profitable since its inception, the company is in the process of establishing its operations, and results may fluctuate going forward. Moreover, the market for aesthetic devices is highly volatile and characterized by rapid technological changes and product innovations. Cutera is essentially a capital equipment company, and quarterly results can fluctuate depending on systems and upgrade sales. In the third quarter 2007, 88% of CUTR revenues came from systems or upgrade sales. This was down from fourth quarter 2005 contribution of 92% and 90% in 2006. The reduction is largely due to Titan disposables that will provide CUTR with some recurring revenue stream. The handpieces provide about 100,000 shots (about 30 patient applications on average) and need to be refilled at a customer cost of about $3,000. In third quarter 2007, Titan refill revenues were $1.2 million, up approximately 14% on a year-over-year basis but flat sequentially. Management expects Titan refill revenue to maintain a double-digit growth pattern.
Rather than facing a costly trial and a potential lengthy appeals process, the company settled its laser-based hair removal patent infringement litigation with Palomar Medical Technologies in June 2006. Palomar, with licensed technology from Massachusetts General Hospital, had filed a patent infringement lawsuit against Cutera in 2002. The suit was scheduled to go to trial June 19th 2006. Although Cutera admitted infringement as part of the settlement, the company removed a major management distraction and stock overhang. Customers are also reassured, removing the possibility that Cutera's hair removal products would face a market injunction. As part of the settlement, Cutera and Palomar agreed to refrain from asserting any further patent claims against the other's current product offerings. The settlement provides that Cutera make a one-time estimated payment of approximately $22 million to Palomar for royalties past due, accrued interest, penalties, and legal costs. Since the settlement announcement, the company stated that the actual amount due to Palomar was $19.6 million. Out of the $19.6 million, $1.2 million has been capitalized as an intangible asset. The $2.4 million (difference between estimated payment of $22 million and the actual amount of $19.6 million) will be used as a credit against future royalties. In a rather favorable outcome (compared to market injunction, or much higher penalties), the company will pay a forward 7.5% royalty for all light source hair removal systems. For systems with two or more hair removal light sources and one or more light sources not for hair removal, the royalty rate is applied to 70% of the system price. If the system has only one source for hair removal and one or more light sources not for hair removal, the royalty is applied to 50% of the system price. For instance, in a multi-application XEO system, the royalty would be applied to 50% of the system, or a net 3.75% royalty. However, if the XEO system also includes the ProWave handpiece, the royalty would apply to 70% of the system price, or a 5.25% net royalty. Approximately 10% of company revenues are full light source hair removal systems and roughly 10% are not hair removal systems. The remaining 80% are multi-application systems. As such, the company expects a blended royalty rate of approximately 3.5% of total revenues. Titan products are not affected by the settlement, and no royalties apply. The settlement has some positive growth implications for the company. There were probably some customers that would not purchase from CUTR because of the uncertainty associated with the patent litigation, but that uncertainty is now removed. In first quarter 2007, the royalty impact was approximately 4% and a similar level in Q207. Due to the royalty as well as lower margin upgrade revenue, gross margin YTD 2007 has declined from the full-year 2006 level of 70.3% to 66.4%.
Summary: We believe CUTR has built a leadership position with continual product development that offers expandability for its core and non-core markets. The patent settlement with Palomar removes a major distraction and reduces customer anxiety. However, weak second and third quarter product revenues could be partly due to sales productivity issues and might be a temporary situation, the weakness suggests to us the market growth of traditional markets like hair removal, even though the company is focusing on non-core dermatology customers, is slowing. Perhaps signaling more a more difficult environment, CUTR is discontinuing providing forward guidance. Given the largely discretionary nature of the aesthetics business, economic weakness reduces visibility and expected growth. As well, competition for the newer non-traditional customer is becoming fiercer. As such, we believe the company will now perform more in-line with the aesthetic market. Given the valuation, our rating is Hold.