Description

The Beauty Health Co (“BH”) has six things investors want in a stock:

1. as a razor/razorblade model, its financial profile is driven by high margin, recurring revenue from its consumables business,
2. it is trading at very cheap multiples (i.e., 12% 2024 FCF yield, 17% 2025 FCF yield),
3. it is the dominant player in the category with attendant scale and network advantages i.e., direct competition is not a primary concern,
4. penetration of the platform is still low, especially in Europe and Asia, enabling the company to compound revenue at >20%/year in 2023-2025 and reap the benefits of embedded operating leverage,
5. the stock is currently out of favor (down ~60% over the last 12 months and down ~80% from all-time highs), but the narrative should improve significantly from here as the company delivers on its 2023 guidance, and benefits from a significant upgrade in CFO,
6. the company has repurchased 12% of its stock in the last 18 months, and last month announced a program to buy an additional 13% of shares at current market levels.  Recently, management has personally bought $130k and board members (including both the chairman and long-time PE fund owners Linden Capital) personally bought $1.2mm at $6/share in August.  Insider ownership stands at 10.8%.

As laid out below, the crux of the thesis is that every year, BH sells thousands of HydraFacial machines to doctors and aestheticians around the world and adds another layer of annuity-like 90% margin gross profit, which largely drops to the bottom line.  Poor forecasting by the prior CFO led the company to miss 2022 EBITDA guidance by $2mm, and miss 1Q 2023 consensus revenue expectations by $4mm (or 4%).  This led to an outsized level of fear surrounding the company’s outlook. 

Based on my diligence, channel checks and conversations with management, I believe the company is on track to meet 2023 market expectations, and that the shares can more than double during the next 6-12 months (back to where they were 6 months ago) to $12, with the potential to appreciate to $18-24 over the subsequent two years.

Overview of Business Model

Beauty Health operates the HydraFacial platform.  Launched in 2005, HydraFacial is a razor and razorblade business: it sells a medical-grade machine / device that dermatologists and aestheticians use to give consumers a standardized, pain-free facial.  (Although the HydraFacial process can be used on many other parts of the body, over 95% of treatments are on the face).  The treatment itself involves exfoliation of the skin, opening up and cleaning of pores, and infusion of a chosen serum (containing antioxidants and collagen) to hydrate and ‘nourish’ the client’s skin.  This compares to the traditional method of literally pinching the client’s face by the aesthetician.

To operate a HydraFacial machine, doctors / aestheticians need to buy recurring consumables (serums and tips) directly from the company i.e., the machine is not compatible with third party product.  Clients can personalize their treatment further by adding one of 25 ‘boosters’ which are essentially add-ons to the consumable that address specific concerns.  The boosters are largely partnership formulas with the best brands in the industry e.g., the Murad Retinol booster which minimizes wrinkles, the NassifMD Hydration booster, the J. Lo Beauty booster, etc.  The company will sell ~$210mm in consumables in 2023 and ~$280mm in 2024, and these carry gross margins of ~90%.

Unit Economics

BH sells devices for ~$25k to medical spas (“medispas”), clinics, dermatologists, and spas (including those found in high-end hotels, gyms, cruise ships, etc.).  Looking at the cohort data, these small and medium businesses become sticky (and overwhelmingly happy) consumable customers for years to come.  Gross churn of machines is roughly 5-7%/year (of which over half is involuntary).  In other words, customers typically stay well over 10 years with HydraFacial, buying an increasing amount of consumables annually, as further illustrated below.

There are two important reasons that independent businesses possess such strong affinity to the platform.  First, independent medispas use the HydraFacial brand and marketing ecosystem to build a business around themselves.  In the same way that an independent franchisee acquires a Planet Fitness or European Wax Center franchise to drive foot traffic to their gym or waxing salon, aestheticians buy a HydraFacial device and advertise it to establish credibility and get customers in the door.  HydraFacial is usually among the least expensive services offered by medispas, and is often used as an opportunity to cross-sell other treatments.

Second, the HydraFacial product offers very attractive returns on capital.  The proof of the above two points is that a) the company estimates the aesthetician level NPS score is 80 (well above companies like Botox) and more importantly (and easier to quantify) b) it generates quick paybacks on investment.  After speaking to several aestheticians in the US and Europe, it seems that payback on a ~$25k HydraFacial device is between 4-6 months. In some countries like China, the paybacks are even faster.  Using an average of 6 treatments per week (consistent with my diligence and company commentary):

In 2023, the company is expected to generate $460mm in total revenue.  As of Q2, 44% of revenue is from (90% gross margin) recurring consumables, and this segment is growing >30%/year (vs 32% growth in 2022).  I forecast this segment to continue growing 30% next year and over 20% in 2025.  The remaining 56% of revenue is from delivery systems (devices), which carry 60%+ gross margins.  The devices provide an important component of the business model, as operators that purchase a HydraFacial machine essentially become exclusive to the brand with respect to facials (i.e., I have not yet found anyone buying two different brands in one location).  In other words, the devices provide a nice lock-in for those customers.  Geographically, 54% of revenues are in the Americas (mainly U.S.), 24% in EMEA and 21% in APAC (with China as a huge growth driver and offering a large upside case).

Currently the market cap is $647mm and net debt is $185mm.  I expect the company to grow total revenue by 26% to $460mm this year (at the bottom end of its annual guidance of $460-480mm, which was repeated in August), and to generate $85mm in EBITDA (i.e., an 18% margin) which is slightly below the mid-point of its guidance.  The company guided on their 2022 Analyst Day to 2025 mid-term targets of $650mm (19% CAGR from 2023E) and a mid-point EBITDA of $180mm / 27.5% EBITDA margin).  At the mid-point of its guidance, SKIN is trading at a 5.0x EV / 2025 EBITDA.

Large and growing TAM

BH is facing an enormous TAM by all indications from numerous channel checks, aesthetician NPS scores, and looking at the penetration of comparable products like Botox.  McKinsey estimated that addressable doors are 500k globally for BH, whereas the company only has ~30k installed devices currently (which likely implies <25k doors, as some clinics have more than 1 machine).  In the U.S. (its most mature market) BH has ~15k doors whereas Botox alone has more than double that count, yet HydraFacial should eventually be in the vast majority of medispas and clinics and is also sold in several places where Botox isn’t such as hotels (e.g., the Four Seasons, Westin, Omni, etc.), Sephora and Ulta stores, Equinox gyms, John Lewis department stores (in the UK), etc.  The market for HydraFacial is expected to compound by 15%/year over the next decade according to Polaris Market Research (https://www.polarismarketresearch.com/industry-analysis/medical-spa-market), in part driven by private equity discovering the wonders of the beauty space, rapid paybacks on those locations and the enormous white space available.

Strong and growing moat

The moat for HydraFacial is two-fold and provides one with comfort in the durability of the platform and royalty-like nature of the consumables business.  On one side of the ecosystem is the fragmented distribution network and on the other side the consumer demand needed to make it worthwhile for that network to ‘show up’ in the first place.

Regarding the distribution network, SKIN has 40k trained and certified aestheticians (that go up in the certification ladder depending on training and volume) around the world.  This has been achieved through years of training, partnering with 80+ aesthetician schools, and continual production and refreshment of online content.  Re-creating this network would be extremely resource and time-intensive as it is built one trained aesthetician at a time.  As aestheticians use this machine, they become more confident selling the product, and more effective at upselling one of the 25+ boosters to optimize the user experience.

Once a small clinic has invested a large amount of capital and effort to learn and bring their customers onto the platform, they almost never switch to a competing brand.  Indeed, most HydraFacial treatments at medispas and dermatologist offices are sold in prepaid packages of 6-12 treatments.  These dynamics have collectively enabled HydraFacial to maintain and build off of its first mover advantage, with the company possessing over 90% share in the device-enabled facial market.  Meanwhile, device-enabled offerings should continue taking share from manual facials given the significantly more pleasant, controlled experience, chemically personalized serums, and ability to literally see the blackheads and impurities extracted from your skin afterwards.  With a higher price point, device-enabled facials also drive a larger $ market.  As customers often buy these in packages, this allows aestheticians to lock in more visits and increases the opportunity to cross-sell other treatments, in addition to different boosters for the client’s HydraFacial.

Market Share / Competitive Landscape

To visualize HydraFacial’s market share, one can look at Google Trends, interview aestheticians or track the number of doors online.  These indicators confirm that HydraFacial is ~10x bigger than the next bigger player, DiamondGlow, which is owned by Allergan . Although Allergan is a well-capitalized owner, DiamondGlow has not materially grown for years, and I have learned from diligence that it is not, nor has it historically been, viewed as a priority business line or opportunity within AbbVie.  Notably, Allergan tried to buy HydraFacial several years ago, and created this copycat when the acquisition was unsuccessful, but it has proven much harder to re-create than they likely expected.  Other copycats like Glo2Facial are a tiny fraction of HydraFacial’s size and scale and appear to be managed for survival versus aggressive growth.

From a market awareness standpoint, with the company already generating ~$460mm in annual revenue and investing ~10% in marketing for the last several years, this creates a high barrier for a newcomer i.e., they would likely need to burn $50mm per annum for a long time before they reach brand recognition and distribution network scale.  This dynamic is reminiscent of other franchised systems, whereby it is hard to compete with scaled franchises because they can spend heavily on mass marketing, including in national channels. 

Global Google Trends Data:

U.S. Google Trends Data:

Strong Recurring Cohorts

Recurring user / cohort behavior is a critical underpinning of the investment thesis, and addresses natural questions on risks to future revenue.  Having spoken to a total of 25 aestheticians and dermatologist offices directly thus far, the summary is that recurring end customers are responsible for 70-80% of HydraFacial treatments.  These are mostly females, but increasingly males as well, especially in the younger demographics.  

Not only are end users sticky, but they tend to increase their usage over time.  Recurring customers get anywhere between 4-10 treatments a year, providing an attractive return for aestheticians’ efforts in selling it.  This also allows them to cross-sell those customers on other services, such as Botox, micro-needling, and so on.  

I’ve run a few surveys and average treatments sold per machine per week in the US is around 6x, above the company’s average of 5x, and aesthetics expect that frequency to continue growing.  I suspect the company average is lower than my survey findings as markets outside the US are less mature (have a higher percentage of new machines with less than 24 months of operation).  The latest survey I’ve seen (by a firm called BWG) estimated that two years ago aestheticians were doing four treatments per device, are doing six now, and expect to do eight in two years.  

While I don’t underwrite to a 33% increase in ‘same device volumes’ over the next two years (excluding price increases), I’m confident that frequency will not come down.  Said differently, investors have the tools to conservatively model SKIN a couple years out and see that this is not a fad, but rather a company with strong recurring cohorts, that generate attractive returns on capital for the company and its aesthetician customers.  It’s important to also remember that the company is not selling to end users directly, and that the medispas, hotels, dermatologists, etc. that purchase the machines possess an additional ‘layer’ of safety for consumables volumes, as they can always lean more into incentives and marketing to keep up footfall / machine utilization.

Although the above conclusion was reached through surveys and interviews, it is also supported by the below disclosures that the company uses to illustrate the predictability of the business, and that there is ‘pent-up earnings power’ today simply because machines take roughly two years to mature.  Given the fast growth, 40% of devices are less than 2 years old, this implies a significant ramp is still happening for consumable sales. 

The below chart is critical in appreciating and visualizing the natural tailwinds in consumables revenue growth:

Low churn

As it relates to aesthetician churn, the company estimates gross churn at around 5%.  Churn jumped around in the last couple of years given the increase of trade-ins associated with the company’s new generation machine called Syndeo (every 5-7 years they launch a new model and customers have the option to trade in recently purchased machines).  Adjusted for the incremental incidence in trade-ins (which appears to be 500 devices in 2021 and 2,000 in 2022), churn has been around 6%.  

Churn looks cosmetically lower in 2023 as a lot of machines in China that were offline for more than a year given the Covid lockdowns came back online in 2023, which artificially helped reduce churn in 2023.  All in all, 6% appears to be a good working number. The below estimation is calculated using devices installed at the beginning of the period plus devices sold minus devices at the end of period, the resulting are devices churned and I subtract the abnormally high trade-ins (pushed by the previous CFO who pursued that strategy which will not be continued in the future).

Margin inflection ahead

As laid out below, I believe that the company is on the cusp of a significant margin inflection, and management has eagerly confirmed its belief this will be clear in 2H 2023 results and beyond.  The primary reason for this is that the company overinvested in growth the last three years, which has suppressed margins.  Management provided some guidance in their 2022 Analyst Day as to how margins would scale, and it also recently upgraded its CFO with a highly successful / proven operator (his last company, Nutrisystem, was an 8x during his tenure) who possesses a more disciplined and data-driven approach versus the private company ‘growth for the sake of it’-type CFO previously. The CFO change was made on August 9 this year.  

The Board’s and CEO commitment to hitting the 2025 margin targets plus the new CFO mandated to streamline the business further should result in a laser-like focus on achieving their 25-30% EBITDA margin target in 2025.  Critically, these are not heroic targets: SKIN generated 23% EBITDA margins in 2018 before pursuing a number of investments in the internationalization cycle, and before it built out this incredible layer of recurring consumables revenue with 90% gross margins.  It is important to note that gross margins overseas are on par with the US, while labor expenses are generally lower.  EBITDA margin of 13% in 2022 have been guided to expand to 18% in 2023E demonstrating clear progress on the path to 25% - 30% margins. 

Adjusted gross margins have trended around 75% in the past.  Unadjusted gross margins reflect impairments driven by over-buying of inventory during the pandemic.  I expect gross margins will trend above 70% again in 2-3 quarters.  Sales and marketing should come down as marketing expenses come down from a currently high 12% of sales to a more normal 6-7% of sales.  Last, G&A was inflated by one-offs and severance from management changes in the last two years. EBITDA adjustments have increased in the last two years driven by one-off management changes and operational challenges with the launch of the new generation device called Syndeo (which drove extraordinary recalls this year); both topics are discussed in detail below and I expect such adjustments to be non-recurring.

This all results in highly attractive returns on capital

As of Q2, total capital employed in this business is $152mm in working capital (which I believe will shrink under the new CFO), $18mm in PP&E and $125mm in goodwill for total capital employed of $295mm.  NOPAT in 2023 should be ~$63mm yielding a 21% ROIC.  Bear in mind, I believe the Company is operating with excess inventory and below normalized margins.  If I exclude goodwill in this calculation, ROIC is 37%.  The punchline is that this is a business with excellent returns on capital.

Return on investment for aestheticians are also nicely positive with paybacks under 6 months, as previously illustrated.

Why is the stock so out of favor and why invest now?

There are a number of factors that have weighed on the stock price including being a former SPAC, management changes, missed guidance, excess inventory, and temporary operational issues with the roll-out of Snydeo.

First, the company went public through a SPAC.  This fact is understandably a bad starting point for investors, but as you can see above, this is a substantive and profitable company, not a theoretical battery business.

BH has made significant management changes over the last 2 years.  The company went public in November 2020 with the CEO abruptly leaving in November 2021 following disagreements with the board over potential M&A (as I understand it).  Given the lack of disclosure on the disagreement and the broad market sell-off, the stock declined precipitously.  In February 2022, Andrew Stanleick was appointed as the new CEO.  Stanleick is a long time L'Oreal executive with a lot of experience in EMEA and Asia, and was more recently head of a business unit at Coty that is bigger than BH.  He has been heads down focused on fixing some of the overspending issues created by the previous team.

The CFO was upgraded in August 2023 as the previous CFO, who was primarily focused on growth as opposed to cash flow management, was an ineffective communicator.  Michael Monahan, the current CFO, was previously the CFO of Nutrisystem, a highly successful turnaround and eventual sale story in which investors multiplied their 8x during his tenure.  Among other responsibilities, Monahan was tasked with bringing working capital back to historical levels, and optimizing the allocation of sales & marketing and other resources based on LTV/CAC.  Shortly following his appointment, the company authorized a $35mm cost reduction plan.

Under the former CFO, the company missed 2022 EBITDA guidance by $2mm (after having increased guidance by $10mm earlier in the year), and missed 1Q 2023 revenue by $4mm (or 4%).  This was driven by a record of uneven forecasting which confused the market.  For context, the company guided to $25mm EBITDA in 2021 and delivered $32mm.  In 2022, BH originally guided to $40mm, upped the guidance to $50mm, only to deliver $48mm.  Perhaps because of its SPAC heritage and large uplift in projected EBITDA in 2022-2025 resulting from rapid revenue compounding coupled with a return to historical margins, the Street has placed exacting standards on quarterly earnings accuracy, and small revenue or top-line misses discussed previously and below have caused a sharp de-rating of the stock.

Finally, there was an operational issue with the roll-out of the new generation device called Syndeo. Syndeo is better than the existing Elite device in that it captures customer data, it incentivizes aestheticians to up-sell boosters, it has additional ports for other types of treatments in the future, and it is harder to use counterfeit consumables with due to the design.  However, the new machine had a clogging issue when it was initially rolled out, with ~2,500 machines (I estimate) sold last year being impacted.  

After interviewing a few large operators (with over 100 locations between them) and speaking to management, I am confident that the issue is fully resolved and new machines deployed do not have this clogging problem (which was solved by changing the width of some ducts).  This type of issue is not rare with new generation medical devices and I understand from the same conversations with medispas that the impact on the brand was non-existent as the company essentially overspent (i.e., meaningfully impacted margins / EBITDA) in addressing these issues for customers.  In short, this created a $1.4mm charge in 2Q 2023 (labeled as “Syndeo product optimization”) and the company explained on its earnings call that 3Q will be the last quarter such a charge will exist.

Insider ownership and board

The Chairman of the board, Brent Saunders, is the former CEO of Allergan (which had pursued the acquisition of HydraFacial and started DiamondGlow essentially).  Saunders owns 8.5mm shares (6.4% of the company) as a result of the SPAC and subsequent open market purchases, and hasn’t sold a share.  In short, he comes off as a smart and seasoned dealmaker, and is very engaged in the business.

Linden, the main PE owner has also kept the majority of their holding and own 25% of the company with representation on the Board of Directors.

In 2022, the Board authorized a $200mm buyback program, and authorized a new buyback program of another $100mm last quarter, representing ~13% of the company at current trading prices.  As previously mentioned, $100mm will be more or less produced in cash flow next year, creating the prospects of additional buybacks if the shares remain so deeply undervalued.

Primary risks and mitigants:

There are a handful of risks I continually think through, although believe I am getting more than compensated for at the current valuation:

• Discretionary spending exposure
  • As discussed, the low penetration of HydraFacial in all markets has and should continue to enable secularly-driven growth through a global economic downturn.  This is particularly pronounced in Asia-Pacific (“APAC”), which the company estimates is only at ~1% penetration.  APAC represents ~21% of revenue but has been growing at ~67% this year, with ~40% growth expected in 2024, creating an attractive mix effect over the next few years.
  • During the last meaningful consumer recession, BH was a much smaller company, so its history of growing through it is helpful but of limited comfort.
  • More importantly, given the recurring nature of consumer behavior with multi-use packages, I believe the habitual nature of the product, and low price point within the beauty space, collectively reduces the sensitivity of the business.
• Management team credibility – with historical guidance misses and execution snafus, does the team have any credibility at this point.
  • There is without a doubt a lack of credibility for the team.
  • In some ways this is fair, and in others the current team is shouldered with the mistakes of the previous management. 
  • Overall, my view is that Stanleick has done a good job protecting the brand with aestheticians after the Syndeo issues, which came at the cost of short-term profits.  
  • This seems like the correct decision for the business and ultimately credibility will be a function of their ability to hit the 2025 targets.
• Excess inventory risk – The Company has taken inventory markdowns and acknowledged they have a surplus of inventory because of the difficulty accessing inventory (both serums and machine parts) during the pandemic.
  • I don’t view this as a structural issue.  If anything, normalization of inventory levels will free up cash and lower the EV accordingly.
  • The new CFO has acknowledged better management of inventory is an obvious opportunity and focus point.
• Fad / competition risk – is this a fad and will consumers continue to use this product.
  • This consumer offering has been around since 2005.  Every year, an additional $45mm+ is spent to grow awareness, in addition to the word of mouth and mindshare that has been achieved by users, aestheticians, medispa owners and dermatologists.
  • Consumer behavior has proven to be habitual with frequent repeat usage, and most users purchasing packages.  Perhaps most important, the cohort data at the medispa level is incredibly consistent. 
  • As discussed, the growing network of 40,000+ trained aestheticians around the world makes it very difficult for another player to displace HydraFacial, even with a slightly better product (and assuming HydraFacial doesn’t adapt accordingly).
• Margins – can the Company really achieve their margin targets?
  • Although covered above, it bears repeating that the company’s 2025 targets rely on hitting margins they have previously achieved when a fraction of the current size.

One way to frame a downside case is that if growth of new machines slows down substantially in 2024 and 2025, I think consumables revenue will still exceed $260mm in 2024 and $330mm in 2025.  At 90% gross margin, even if you attribute 100% of the company’s marketing budget to consumables, this portion of the business will be generating ~$180mm in EBIT in 2024.  At a super conservative 10x EBIT multiple, the consumables business alone would be worth more than 2x the current EV.

Target Price:

The Company is currently valued at a 12% and 17% FCF yield on 2024 and 2025 respectively. 

On a base case, I believe BH should trade at 5% FCF generating a stock price of $18.  This is based on BH hitting the low end of 2025 revenue guidance ($460mm), the mid-point of their EBITDA margin guidance that I believe to be conservative (27.5%), and a 65% FCF conversion yielding FCF of $117mm.  The Company is extremely well-capitalized and repurchasing shares aggressively in the market, with a watchful board ensuring capital allocation remains disciplined.  A different way to frame the downside case than above is to assume 60% FCF conversion and a 9% 2025 FCF yield (i.e., if the company struggles to communicate the recurring aspect of consumables to the market), in which event the stock would still double to $10 per share.

DISCLAIMER:
Nothing contained in this analysis shall be deemed to constitute investment advice or a recommendation to purchase, sell or otherwise transact in any security.  This analysis contains information from sources the author believes to be reliable, but the author cannot guarantee the accuracy of any such information.  The author undertakes no obligation to update or revise this analysis, whether as a result of new information, future events or otherwise.  The author owns shares of the company, and may buy additional shares or sell shares at any time. 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

There are a number of catalysts that can drive the stock price here, but ultimately it comes down to BH executing against its 2024 and 2025 guidance.  If the path towards achieving historical margins again is plausible, the stock will not trade at 17% 2025 FCF yield with revenue compounding at a 20% CAGR between 2023 and 2025, and cash flow compounding much faster.