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Moats and Monopolies
Here at Moats and Monopolies, we write exclusively about companies that we own in our publicly shared portfolio, which continues to beat the S&P500 albeit by less than 1% this past quarter.
Our strategy is to hold a relatively concentrated selection of some of the highest quality compounding companies from around the world, and despite The Beauty Health Company (NASDAQ:SKIN) being hard to quantify with those descriptors, we have followed its progress (or lack thereof) since it turned public. Why? Well, we saw a potential to be niche leader in the lucrative health and beauty space with a razor and blade model and network effect being built almost identically to that of the early days of Intuitive Surgical (ISRG); feel free to read why we love the robotic surgical assistant company here.
Since this will be the 5th article we’ve written in the past year and a half, and in order to get straight into their earnings and not repeat ourselves again: For more on their business model read this; for their last earnings (i.e. 2024 Q1), this.
Company overview in exactly 100 Words
The Beauty Health Company is a global leader in a market it carved out for itself in non-invasive facials. It has a classic razor and blade business model and sells its devices (the razor) B2B, primarily to clinics, skin treatment centres and spas, and has relationships with LVMH (OTCPK:LVMHF)-owned Sephora as well as Harrods of London and Dior Beauty. After devices are up and running, it sells ‘consumables’, which are required for each facial treatment provided (the blades) in addition to more specialised ‘boosters’ that personalise and customise treatments, for example using celebrity endorsements or focusing on certain skin types.
Quarter 2 Earnings
Marla Beck has now been CEO since last November, albeit interim before being permanently appointed in March. With the recent revolving carousel within the company’s C-Suite, it’s good to have someone with her background at the helm: She was the founder of Bluemercury, a health and beauty retail chain that she started, scaled and then sold for $200million to Macy’s (M).
One of her major priorities when she took the job was to focus on cost cutting and making the company more efficient. In that regard, there has been positive progress this quarter with total operating expenses down 28% year on year.
So why is the stock price down if the company is becoming more efficient? Well, two reasons. One, it is experiencing some pressures from the macro environment as high end, luxury facial treatments are almost the epitome of discretionary spending. And two, the company had to write off $17 million for replacements to faulty Syndeo 3.0 machines, their flagship device that has been perpertually riddled with issues since launch. The two combined led to the revenue declining year on year and the cost of goods sold being flat, leading to a drop in gross margins from around 60% to 45% (based on 10Q numbers and not those ‘adjusted’ by management). Whichever set you choose, that’s a huge difference.
Fortunately, Beck said in the prepared commentary and as a direct answer to an later analyst question that the company has “completed our global Syndeo replacement program…all our providers are able to operate on the latest 3.0 standard device”. CFO Michael Monahan later added that, with this in mind, gross margins should return to that of around Q1, i.e. around 60% for the rest of the year.
On devices: the launch of the company’s flagship Syndeo 3 model has not been a smooth one. In hindsight, the company would maybe even be profitable now if it had never existed, particularly as the devices are just the lock in to what should be years of profitable consumable sales. With that in mind, the company have reversed their recent decision (from literally the last quarter) to not push older (and cheaper) models as demonstrable proof of their confidence in the new machines: sharing that this quarter around 30% of the device mix were older models and they a) expect that to increase and b) are open to selling them, particularly to ‘lower the barrier of entry’ to smaller potential business customers. Honestly, we are not in the least interested in which device is used as long as the overall active install base continues to grow healthily, and there aren’t further issues that force expensive replacements to kick the profitability can further down the road. Our thesis has always been that future shareholder returns are based on the consumables (the blades) as a high margin and recurring revenue stream that should grow and scale with the install base, and not on the devices, which should wipe their feet and maybe add a little below the line.
Author’s own work
The installed base grew a net 3,822 devices year on year, an increase of just shy of 13%. This is a sequential slowdown (from nearly 19%), but remember that these are just operational and installed machines, rather than considering upgrades/trade ins etc. In terms of the consumables, as we can see, there has been a steady decline of the amount of consumable revenue being collected for each installed machine. There are some potential reasons for this. New devices come with some already packaged, so any upgrades (or, cough, replacements due to faulty machines) as well as new outright purchases will come with stock to get started and would therefore not need to be immediately replenished. The other elephant in the spa room is the macro uncertainty of certain regions potentially experiencing recession or at least cuts in discretionary spending due to inflation; whether correlation or causation is up for debate, but the blue line starts to go down around the time when interest rates were going up. Beck on the call seemed to imply that the base consumables are selling just fine (with overall consumable sales up nearly 7% YoY, hitting a new quarterly sales record of $55.4 million), but the flattening of sales per installed device stemmed from end users opting out of the personalisable ‘boosters’ and taking the base service. One thing that the company is doing to potentially remedy this is a new booster launch in Q3, which will be their first clinically proven and research backed booster – hopefully at least a good marketing ploy for clinicians to sell these upgrades to their customers.
Beck was asked by an analyst about the impact of the appointment of Sheri Lewis as the company’s new COO primarily targetting the supply chains. She (quite fairly) said that Sheri was still in observation mode but that there would be a plan detailing what she is doing to improve the supply chain and increase gross margins being presented in Q3. Needless to say, we are very much looking forward to hearing the plan considering that a big chunk of the company’s recent problems have been due to devices shipping with technical issues that could have been irreparably damaging to Beauty Health’s reputation.
Beck also announced that she was looking into other products to expand their offerings and that they will be soon looking to ‘wrap the room’ and offer skincare products to end consumers via providers of Hydrafacial in the near future. Skincare products are an incredibly competitive space. Looking at Estee Lauder (EL), one of the global names in the sector, see their shares almost halved in the past year, we cannot really see how this moves the needle in a positive way. In fact, one of our early criticisms of the company was that previous management teams were talking about going into several verticals without extracting value from its core product, one that literally still isn’t yet profitable.
Finally, she discussed how as part of an overall roots and branch review of the company’s sales structures and strategies, particularly outside of the US, they are going to be bringing in consultants, a project that should be completed by the end of the next quarter and we hope that this is shared with shareholders in the next earnings report. Certainly, there are huge areas of the world that are still ‘white space’ opportunities for Beauty Health, so we will remain positive on the efficacy of this investment until proven otherwise.
Final Words
If you are reading this and have held long positions in the company for literally any amount of time, you are probably down on your investment. We are, too. It is times like this when we have to remind ourselves that when buying a piece of a company, particularly one that has been highly volatile over the past couple of years, that current price is the future value of all cash flows discounted to the present, and not something that we should overthink on a daily or weekly basis (unless, of course, you are a trader).
With that in mind, it is important to consider where the company goes from here over a number of quarters, particularly being a relatively new one to the public markets. Are there potential existential issues here? Yes, the company still hasn’t demonstrated that it can be consistently profitable and has at present a net debt; that’s a risk that we as shareholders or potential ones need to be aware of. On the other hand, are the fundamentals of the company improving? Yes, the consumable sales continue to increase and there are more devices in more places now than there were previously, and presumably there will be more next quarter and the one after that. Debt is manageable, management seems to know what they’re doing, the Syndeo roll out may (may) be finally fixed. There are positives, they’re just coming a lot slower than many would like and investors are probably cutting their losses and considering their opportunity costs.
We are long term investors and still feel that there is an excellent asymmetric opportunity here for those who can tolerate volatility and are patient. With that in mind we increased our position in the company both before AND after earnings. Time will tell.
We have decided to downgrade our rating to ‘Buy’ from ‘Strong Buy’. This is not because of the stock price, but because of the extra replacement write offs for Syndeo replacement that we were told were solved in the last quarter. We want to see proof in next earnings’ numbers that the replacement program is complete and we can move forward and the gross margin numbers and revenues normalise again.
As always, we look forward to constructive and respectful conversations below the line.
See you there! MaM.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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