Q2 Earnings: The Untold Story
Why has the market not blessed Palomar's first decent gross margin, and its third consecutive quarterly reduction in losses?
The two main reasons are:
1. Efficient, much lower priced competition is likely to put great pressure on Palomar's sell-price and hence its gross margin.
2. Operating expenses remain uncompetitive and unprofitable.
Let's look at these in greater detail.
Gross Margin
Palomar's gross margin turnaround from 10.3 percent in Q1 to 47.1 percent in Q2, was due entirely to the new LightSheer product, which accounted for about 85 percent of revenue.
I estimate the gross margin on the $150,000 LightSheer diode product at about 55 percent, which means that its cost of revenue is about $67,500 per unit. That is more than the $59,500 SELL price of Candela's new GentleLase product, which appears to have a GP percentage comparable to the LightSheer. So Candela has a huge advantage over Palomar in manufacturing efficiency.
Expenses
Palomar made no significant progress on operating expenses in Q2, which actually rose about $300,000 from Q1.
S&M (Sales and Marketing) was 38.8 percent of revenue, which is ridiculously high. Obviously Palomar is paying a hefty premium for using Coherent to sell its products. To put this in perspective, consider that Coherent has historically spent about 20 percent of revenue for S&M.
G&A (General and Administrative) was 25.7 percent of revenue, which is outrageous, compared to Coherent's historical 10 percent.
S,G&A, the total of the above, was 64.5 percent of revenue - way out of line with Candela's 31.9 percent in the same quarter, and Coherent's historical 30 percent.
R&D was 21.4 percent of revenue, again way out of line with Coherent's typical 10 percent, and Candela's low 3.5 percent in the same quarter. (Candela's R&D is expected to return to its historical 7 to 10 percent of revenue.)
Palomar's total operating expenses were 85.9 percent of revenue compared with Candela's 35.4 percent, and Coherent's historical 40 percent.
Clearly, Palomar's expenses are disastrously out of line with industry norms.
Revenue Growth Will Not Lead to Profitability
The lack of any serious cutting of Palomar's expenses in Q2 suggests that they hope to achieve profitability by increasing revenue and gross profits. In fact, it was revealed in the Q1 conference call that profitability in Q4 was dependent upon a gross margin "well in excess of 50 percent."
I estimate LightSheer's GP to have been at about 55 percent, so that goal may well have been achieved ahead of schedule. However, due to Palomar's exorbitant expenses, revenue will have to increase dramatically just to break even.
Assuming that only LightSheers are sold, at 55 percent GP and 39 percent S&M, and that G&A plus R&D remains fixed at $4,283,000 per quarter, Palomar would need to revenue about $27 million to reach ZERO operating profit. That would be a three-fold increase of Q2's record revenue. Unlikely!
To match Candela's 9.8 percent operating profit in the recent quarter, Palomar would require quarterly revenue of $67 million - more than a 7 fold increase!
Clearly, Palomar cannot expect to grow its way into profitability. And as pointed out earlier, its high sell-price, market share and GP are not likely to hold up under pressure from low-priced competitors like Candela.
Palomar must also be concerned by the present turmoil within Coherent Medical. Its admission that its efforts to sell Palomar's LightSheers detracted from efforts to sell its own products cannot have gone down well with its investors. Consider that Coherent may have revenued a little over $3 million selling LightSheers, but saw a decline of $16 million in sales of its own products, for a net decrease of $13 million relative the year-ago quarter. Heads began to roll at Coherent well before the earnings were released.
Finally, the hair removal laser market may reach saturation over the next several quarters. More than two thousand units may already have been sold worldwide over the past couple of years, but the present products have not been well received by patients, who were led to expect much greater efficacy for the typically high cost of treatment. Despite rosy estimates by the manufacturers salesreps, it is unlikely that many physicians are profiting from this class of product. (That could explain why Candela's stock remains fairly cheap, even after its impressive pop last week - investors may doubt the long-term viability of ALL hair removal products.)
Reading Assignment
Obtain a copy of the July 1998 issue of the Archives of Dermatology, and read Christine Dierickx' and Rox Anderson's ridiculous paper claiming permanent hair removal in their 1994 MGH pilot study. (The Epilaser's patent is based on MGH technology tested in that study.) Then, in the same issue, read the editorial, "A Hair's Breadth Closer?", which criticizes the study design, and questions its findings. It also implicitly criticizes FDA's market clearance process, as a disincentive to the conduct of properly designed clinical studies.
Interestingly, it appears that FDA's recent clearance of Palomar's Epilaser for "permanent hair reduction" was based in part on the findings in the same Dierickx/Anderson paper.
This should be a lesson for investors who still foolishly believe that "FDA approval" is some sort of bankable seal of approval.
Ted Molczan |
