“Freeze the Fat Away … Quick 40% Profit” (Hilary Kramer)

by Travis Johnson, Stock Gumshoe | January 10, 2012 2:32 pm

Identifying the New "razors and blades model" medical device company recommended by GameChangers

I’ll admit right up front that there’s something appealing about this company’s service, at least for your friendly neighborhood Gumshoe … who is a bit more roly-poly than he might like.

It’s Hilary Kramer[1] pitching to us again, teasing us that she’s recommending a company that can “freeze the fat away” and that should be a long-term winner … but also a short term play with an expected “quick profit” of 40%.

And apparently this isn’t just a teaser campaign pick, but it’s also a current selection of the newsletter — the ad, which I got yesterday, says that it’s a new recommendation in “today’s issue.”

But I’ll let her words entice you …

“an exciting new stock that will deliver explosive growth as it revolutionizes the battle of the bulge.

“When you look at the lists of New Year’s Resolutions, year after year, losing weight always makes it to the top!

“But while we like to look good, we don’t always like to put in the hard work and sacrifice it takes to make it happen (which is probably why it stays on the list year after year!).

“It’s no wonder that liposuction and tummy tucks are both in the top five aesthetic surgeries….

“Today’s GameChanger hits the sweet spot of this huge and growing market with an excellent alternative to surgeries like liposuction and tummy tucks.”

Sounds impressive, right? I’m sure it’s wonderful to cure cancer or diabetes[2] or to treat and counsel families suffering from debilitating problems, but aesthetics is a nice, cleaner business without as much stress[3] — I imagine many doctors are just as happy blasting away a little fat or some wrinkles as they would be treating disease … your patients like it, they’re generally wealthier than average and pay their bills, and there are fewer insurance headaches.

And better yet, we’re told, this is a “non-invasive procedure” — which sounds impressive. Even the vain and the frustrated don’t necessarily take kindly to the idea of possibly risky surgeries or scars to get rid of their “love handles.” If I’m not even willing to stop eating candy bars to lose a few pounds, I’m definitely not willing to undergo surgery[4].

Here’s what they do, in Kramer’s description:

“This game-changing new procedure, approved by FDA[5] a little over a year ago, literally freezes the fat away. This proprietary system freezes fat cells, causing them to die off over a few-month period.

“Your body just naturally disposes of the dead cells. There are no incisions needed, and no anesthesia is required. It’s an outpatient procedure with minimal discomfort. In fact, many people return to work after having it done.

“The business is very much a ‘razor and blades’ model, which is typical of medical device companies. The ‘razors’ are the systems doctors need to perform the procedure; the ‘blades’ are fees and supplies associated with each procedure, including disposable supplies that allow physicians to use the equipment for a fixed number of procedures before they have to buy more.”

I know we’ve heard it many times, but I looooove the “razors and blades” model — it doesn’t work every time, of course, but if you can find a company that’s implementing it well and pricing it right the long-term rewards can be remarkable. Just look at Intuitive Surgical (ISRG)[6], a company that has been teased many times over the years, and which I regret selling years ago — revenue growth ramps up in the early stages, albeit in a “lumpy” fashion, as the expensive machine is sold to doctors, then more machines begets more procedures, and each procedure requires a disposable set of supplies, so as the installed base grows the demand for the supplies grows.

If you can sell the “razors” or the base equipment at a profit eventually, so much the better — but often the first phase of growth in the installed base comes at a substantial cost, which is worn down over time by the high-margin supplies business that continues to grow on a larger and larger base of machines. And of course, you have all of these doctors who spent a lot of money to invest in a fancy new machine, so they’re motivated to market their services and increase their usage.

Of course, for big-ticket medical devices this only works over the long term if the machine is really unique (and therefore marketable, with a differentiated service or outcome), and it really works well, and doctors and patients both like it and seek it out — preferably by brand name.

So which one is this?

Well, you may already be able to guess it — it’s a recent IPO[7], and it’s a pretty unique and marketed concept — but it hasn’t gotten all that much press in the investor community that I’ve seen. Just to make sure, let’s gather a couple more details from the teaser ad:

“The company received FDA approval for its system in September of 2010, and early acceptance has been impressive, resulting in rapid revenue growth. In the first four months after approval, revenues jumped to $25.4 million from $1.5 million in 2009. Growth exploded through the first nine months of 2011 with revenues of $49.3 million. Revenues from sales of the system increased 219%, and procedure fees increased 597%.”

And we’re told that the stock “soared” from the IPO by about 40%, but pulled back and is now under the initial offering price. Kramer doesn’t specifically say from whence she pulled that “quick 40% profit” that she’s looking for, but says that it’s a “great time” to buy because “sales are really kicking into high gear.”

So who is it?

Thinkolator sez: Zeltiq Aesthetics (ZLTQ)

Which really is a new company with a new fat-killing technology — their product is called “coolsculpting”, and it basically takes advantage of the fact that fat cells are sensitive to temperature in a way that’s slightly different from skin cells. Their machine consists of a device that vacuums your skin (flabby sections, like a belly bulge or a “love handle”) into a cooling machine and drops it to a set temperature for an hour. This temperature, which is above freezing, apparently does no lasting damage to the skin cells but kills a portion of the fat cells — and kills them in a pleasant and natural way (the process is called apoptosis) that allows them to just be slowly disposed of by the body (no traumatic desctruction that causes stress or scarring, apparently).

It’s meant for “stubborn” problems like the guy who has lost 25 pounds and looks good, but still has stubborn pockets of fat in the love handles or lower back that won’t respond to exercise or dieting; or the new mom with a recovered body but a lingering fat pouch. They’re trying to be very clear that this is for folks who have already done the hard work, but for whom it hasn’t resulted in quite the level of body perfection they were looking for — many folks call it “body sculpting.” It’s not a cure for someone who has a 20 pound pouch of fat in his belly and doesn’t want to go for a jog (insert frowny face for yours truly), it’s a way to make your hard work look better. We can debate whether it’s healthy to have more ways for a society to encourage aesthetic perfection, but certainly there are lots of companies in lots of industries making lots of money as they try to make us feel better about how our bodies appear to the outside world. The device is FDA approved for “flank fat” (that’s not their term) — basically, muffin tops and love handles and persistent back flab.

Zeltiq was funded by private equity for a pretty rapid development phase that had them getting marketing approval for their device and procedures in Europe in 2009 and in this country from the FDA in September 2010. Once they had a couple of months of sales in the hopper, they filed to go public last Summer and actually had their IPO in October 2011. The IPO raised a bit under $90 million by selling about eight million shares (and, importantly, the company raised the money and therefore has the cash to finance growth — it wasn’t just the founding shareholders and early investors who sold in the IPO, though those insiders did sell 307,000 shares as part of the IPO). Coincidentally, that’s pretty close to the company’s “accumulated deficit” of about $80 million (roughly speaking, that’s the money they’ve run through in ~6 years of developing the system).

The financials (their first 10-Q is here[8]) are a little odd looking because they haven’t filed yet as a public company — their September filing before the IPO was essentially for the prior holders of the convertible preferred shares (which were apparently all converted into common stock at the IPO), though you can of course get the basics on revenue and earnings from these filings. I presume that those convertible shares, which now make up about 3/4 of the ownership of the company after conversion, were held by initial investors and insiders. There’s also a pretty good slug of options[9] out there for potential future dilution, though that’s common for a new company. The lockup period for insiders is six months from what saw of the IPO filing information, so there could be some selling pressure if insiders are anxious to sell starting in mid-April.

The “Razor” in this case is their CoolSculpting device, which is a little machine on wheels that does the chilling, and the “razor blades” are the different size cooling vacuum pad assemblies that you can use, disposables (like gel to cover the skin, etc.) and the CoolCard that basically makes the machine work (each card has a certain amount of uses embedded in it, and the machine and controlling software only work with the card). So far, as of the last nine months, about 70-75% of revenue comes from the machines and the rest from CoolCards and supplies. The geographic dispersal is similar — about 70% North America, 30% rest of world (presumably that’s almost all Europe, though they also have other distribution, including in Brazil[10], global capital of plastic surgery). I don’t know what other competition there might be for this specific technology, but they seem to have good control over their particular intellectual property — they have an exclusive license agreement with Mass. General, where doctors developed the patented process (that license lasts the life of the patent, which is currently expected to expire in 2023, and there are milestone and royalty payments due to Mass General — including $6 million they owed as a milestone payment in December for the IPO and an ongoing 7% sales royalty).

The company says they are targeting a global base of 4-5,000 physicians who meet their “target characteristics,” some of whom might buy more than one system. So far, they have an installed base of 812 units as of September 30 — if you do the math, that means the installed base increased by 594 units in the first three quarters of 2011 (they had 218 units before that). 183 of those were sold in the third quarter, so they are not seeing big booms of sequential sales growth (thus the “seasonal weakness” they mention — doctors on vacation in the summer, etc.), though the year-over-year numbers are very good — in large part because, of course, they didn’t sell much of anything in the US before FDA approval in late 2010.

System sales revenue was roughly $35 million for that nine-month time period, so we can infer that the initial system investment is something like $60,000. Which is a fair chunk of change, but certainly not huge for an aesthetics practice where they’re already doing plastic surgeries and liposuction (and, of course, tiny compared to the cost of some medical equipment).

The company says they “shipped 44,000 procedures” to their customers in the third quarter last year, though I don’t believe they’ve disclosed what company revenue is per procedure or how many they expect to do in a given quarter. They did say that their expectation is for the second and third quarters to generally be seasonally weak, so perhaps they’ve set it up — as most companies try to do — so they have an impressive looking quarter their first time out.

The average cost of a single procedure is in the $600-700 range for a single hour of a single location (ie, one “love handle”), and apparently most folks would do a couple applications. Bigger applications, like a belly, would be perhaps twice as much per hour. Zeltiq is targeting both a group of about 20 million “veteran” aesthetic procedures customers (mostly wealthy, middle-aged women), and the much larger group of “novice” targets — healthy appearance-conscious people in their 30s-50s who might have stubborn “problem areas.”

So far the analysts all give ZLTQ a “buy” rating — but of course, those are also the analysts from the same investment banks who managed the IPO for Zeltiq just a few months ago (and, cynics will note, would like to manage any follow-on offerings). They do have a good slug of IPO cash that should support a pretty strong growth strategy — particularly the big ramp-up in sales force that they need right now, and the consumer marketing that will help drive demand, though they also have to ramp up manufacturing capacity if demand rises as they expect.

I have no idea if this marketing and buildout will work, or if other things like laser liposurgery or whatever will prove to be more popular as noninvasive or minimally invasive fat-fighting options — and likewise, I don’t know if the patients have generally been happy with results so far (the company says yes … of course). And likewise, I expect there’s plenty of risk if one of their doctors uses the system to do something outside the lines, or if there’s some accident or unforeseen problem with the system. They’re a very small company — about $350 million in market cap now, with the share price now down to about $10 — and their only real asset is this “cool technology.” They are investing more in R&D, including an expansion of their work with Mass General to fund more research into other aesthetic applications of this cold technology, and they probably won’t show a profit this year.

There is certainly potential for profit, and for that profit to scale very rapidly if the product takes off with consumers, since it’s inherently a high margin business (gross margin is already at almost 60% even with their low initial sales — it’s the building of their sales force, more R&D, and their corporate costs that suck up the cash, not the cost of producing the machine, and the recurring supplies revenue is at substantially higher margins than the systems sales). You can check out their marketing (coolsculpting.com[11]) and their investor presentations[12] and choose for yourself.

I’m personally kind of intrigued by this one, though I’d be much more comfortable if they had at least one publicly reported quarter under their belt after the IPO (and a quarter that they didn’t say was “seasonally weak”). I don’t know when their fourth quarter report will come out, but given the very early stage of their sales ramp-up it’s very possible that the numbers could cause a substantial move in the share price — of course, that could mean “down” as well as “up.” Clearly, investors are not enamored of this one right now (it’s down a bit this week, despite their presentation at a health care investing conference yesterday), which is a bit worrisome — but perhaps not a surprise for a new IPO that hasn’t yet proven itself.

For companies like this who have “lumpy” revenue that depends on bigger-ticket system sales, an earnings miss on a bad sales quarter can often present an opportunity if the adoption rate and usage rate of the installed base is good — but that’s a hard bet to make when they haven’t even really reported one quarter yet, and when the stock is just getting its first analyst coverage and the lockup period hasn’t even expired to give an idea of what insiders are doing. Intriguing, but still certainly a gamble on a product that’s just ramping up — if you know more about Zeltiq or have an opinion on CoolSculpting or the price of ZLTQ shares, let us know with a comment below.

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