Moats and Monopolies

Here at Moats and Monopolies, we run a concentrated portfolio of high-quality compounding assets from across the world. This is shared publicly and openly on Seeking Alpha. We have been researching The Beauty Health Company (NASDAQ:SKIN) since it first went public. We initiated a Buy Rating 6 months ago in this article in which we go into depth about the company. In this article, we will look at what has changed with the company in the first 2 quarters of 2023, and determine whether the thesis is on track and whether we will open a position.

Quick Summary of SKIN

The Beauty Health Company is the producer of the Hydrafacial product, a medium to high end cosmetic procedure during which the skin from primarily the face is given a deep clean. These are typically administered by beauticians in spas and beauty salons. The company has a razor and blade model, whereby the machines are sold to the spas and then proprietary consumables are then sold to beauticians for use during treatments. In our original article, we explained that this is then made more lucrative by what the company calls ‘Boosters’, which are customisable elements to the facial that personalises the experience for the client and are often attached to a celebrity endorsement, for example Jennifer Lopez.

We were also impressed with how the company was focusing on the training of beauticians in a move out of the Intuitive Surgical (ISRG) playbook, in creating a network effect of trained professionals who were unlikely to want to retrain or be upskilled to rival platforms in the future. At the time, The Beauty Health company had 35,000 clinicians trained to use its products and had created what it called an MBA for aesthetics, which offered advanced training courses.

The main risks we identified last time round were based on risks of an upcoming recession, or at least reduced discretionary spending within the current financial climate leading to fewer visits to spas for expensive treatments, and execution risk as the leadership team had experienced some changes in the C-suite with a post IPO CEO change, and their current plan seemed very ambitious for such a young company.

Changes in the past 6 months

We discussed that there had been changes in the senior leadership team in our previous article, and since then we have another transition – Michael Monahan, formerly of Casper Beds and the weight loss supplement maker Nutrisystem replaces Liyuan Woo as company CFO. We are hoping that we do not see further changes for a while.

On the financials, the company has seen quite large drops in gross margin over the past 6 months, in part stemming from ‘teething issues’ with the role out of the flagship Syndeo machine in the US meaning that some have had to be replaced. According to the CEO on the 2023 Q2 earnings call, these are expected to go up to ‘historical levels’ by the middle of next year, so probably Q1 2024. On the one hand, it’s important to maintain positive relations with their customers and replacing faulty machines is better than the alternative of having an expensive new device being repaired so early on in its lifespan, as the company hopes that spas will purchase consumables for many years to come. On the other hand, and as previously pointed out in our original article, the company spends very little on actual research and development (around 2.5% of revenues last quarter), which is surprising for one that is moving into lots of different verticals. We hope that enough care is being taken on the development of these expensive machines compared to the costs of marketing them.

Further, they are still not creating consistent earnings or cash flows so it was surprising to us to see the company using its cash reserves post IPO to repurchase its own shares. This may well be a sign of confidence, seeing the company as undervalued and sensing an opportunity for better future investor returns. It could also be financial engineering, a point alluded to by one of the analysts on the earnings call. We will hold judgement for now, but do question the efficacy of share repurchases so early on to a possible hyper growth story.

The recently promoted COO Brad Hauser played more of a role in the most recent earnings presentation, and discussed a few of the company’s new directions. First of all, they are starting to sell refurbished older machines, namely the Allegro. This wasn’t something we were hoping to see as the Allegro is now 4 generations old having been first released in 2012. The spin was that it “offers [pricing] flexibility…particularly [to] newly graduated aestheticians.” Whilst we do understand the importance of the blade/consumables to the business model, it could well point to weaknesses in their internal guidance for future Syndeo sales, which retail at around $40000, far below the average machine price sale of around $23000 Q2 (down from $25000 Q1), showing that the product mix is skewing cheaper over sequentially. We will pay close attention to this number over the next few quarters.

More exciting for us as big fans of the value add customisable consumables – Boosters. Hauser also talked about the inevitable development and release of Regional Boosters, which will focus on specific target skin care types – read China, which the company sees as a massive opportunity.

Further, and as anticipated in our last article, the company is also developing a direct to consumer skincare range, which is seen as “a logical extension that…puts Hydrafacial in consumers’ homes”. This is a tough market. One only has to look at Estee Lauder’s (EL) recent difficulties in the space. It is not our favourite vertical for the company to move into – niche fancy spa treatments are fine but taking arms against the Global cosmetics industry super players seems an unlikely battle to win.

As also discussed in the last article, the company is continuing its plan to move into the potentially lucrative hair restoration industry with a specific Keravive device, designed “for the tight quarters and the economics of a hair salon”. Moving into high end hair salons seems to be a much better fit for us than the aforementioned direct to consumer product and we are looking forward to numbers from these sales over time.

Finally, the company recently discussed its plans to hook up its data creating Syndeo machines via collaboration with AWS to launch a Syndeo Cloud. We genuinely don’t fully understand how this is accretive for the company as the data it receives will likely align with sales data in determining which consumables are being used. It is being released with a consumer loyalty programme, which presumably will then allow the company to align sales data with more intimate data relating to skin types/colours, ages, etc of those using treatments. Again, assuming there is wide uptake for this (which we doubt), it is not immediately clear how this pushes the needle.

Financial Update

In the past months and last 2 quarters, we have seen steady improvements to the company’s sales. We can see below that revenue growth is trending upwards and as of the most recent quarter, has doubled from IPO. This is good to see. We can also observe that Q2 each year shows very strong sequential growth and we can forecast that Q3 will see a dip in sales, based on the past 2 years data. Should it be steady or even grow, we would see it as a positive sign for the company.

In the chart below, we can look at the razor and blade of its business model. The red line below shows the total net install base, which includes faulty system replacements as well as upgrades to older machines, of which nearly half are nearing a decade old and moving closer to potential upgrades to Syndeo. We are pleased to see that the curve is starting to accelerate upwards, presumably as the company’s flywheel of actively training beauticians (now over 40,000 trained) and celebrity endorsements takes effect. The blue line is data that we created that simply divides the install base (the razor) by the total revenues from consumables (the blade). Interestingly, it is relatively flat over the past few years, whereas we would have hoped for that to increase as customers sold repeat services to their consumers.

This can be further seen in this slide from the Q2 presentation, which breaks down cohort spend from pre 2017 onwards. The relatively flat bars for the earlier cohorts shows that there is a potential weakness in either pricing power (for either or both the company and its customers – the clinics) or in repeated treatments. Do some consumers try it based on what they’ve heard but not appreciate the results enough to make it part of their regular beauty routine? We will be paying attention to this consumables / machines installed metric moving forward.

Valuation

Below is a table that details the full 2021 and 2022 revenue results and, in italics, our assumptions out 10 years until 2033. The 2023, 2024 and 2025 forecasts are taken from Seeking Alpha and then tapered off.

Click to enlarge

Valuation Assumptions:

Management recently reiterated their confidence in 2025 of having an adjusted EBITDA margin of 25-30%. We have taken 25% and assumed no further margin increase up and until 2033. Further, we’ve assumed that the adjustments will total 10% and that the applied tax rate will be 25%.

This leads us to 2033 (in millions):

Revenue of $1278

Net profits of $144

Forward PE of 4

Net income margin of 11% (roughly in line with the 5 year average margins of Estee Lauder and L’Oréal (OTCPK:LRLCF).

If we take market average multiple of PE 15, this gives us a valuation in 2033 of $2.157 billion. Today, the company is valued at around $580 million.

This gives us an annual return (assuming no change to share count) of 14% per year.

Final Words

The Beauty Health company has a very ambitious and, in our view, slightly unfocused plan for the next few years. This includes rolling out its flagship product the Syndeo machine, releasing new devices, spreading into new territories, offering a direct to consumer product line, and continuing to train legions of beauticians.

We maintain that the company’s biggest risk is that of execution. Valuation wise, if the business can grow into its various verticals there is a lot of potential here and sits right at the far edge of the risk reward spectrum for asymmetric investors.

For us here at Moats and Monopolies, we see it as a very tempting proposition and will continue to monitor. We are watching a couple of metrics very closely: The increased roll out of machines and their average retail prices, the amount of consumables sold per machine as well as that balance sheet as cash starts to dwindle. We maintain our Buy rating and might look to initiate a position into the Moats and Monopolies portfolio pending Q3 or Full Year results.