Beauty Health Co.'s stock rockets on business transformation plan and is still severely undervalued

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When a company goes public, it takes on new responsibilities, including complying with strict SEC rules and reporting quarterly to Wall Street. This means that it must operate efficiently and have systems in place to ensure that its financial reporting is accurate, which can be challenging for newly listed companies that often have inadequate processes in place.

Beuty Health Co. ($SKIN), the creator of the patented Hydrafacial treatment, is a recent example. The company's stock has lost more than 50% of its value in the past five months due to inaccurate financial forecasts and other reporting issues. The company has taken steps to improve its financial reporting, such as replacing its CFO and overhauling its internal processes.

The stock surged 26% yesterday after the company announced that its business transformation program under the new CFO will result in tens of millions of cost savings in 2024.

Despite the short-term challenges, SKIN's signature product, the Hydrafacial, is still in high demand. The addressable market is large and growing, and the stock is still cheap, making SKIN a good buy, even though there are some risks. Let's take a dive.

System Issues Causing Short-Term Disruptions Despite Strong Demand For Hydrafacial

SKIN is seeing strong demand for its Hydrafacial offering, even in the face of a tightening credit environment. The company sells its systems once but makes recurring revenue from the sales of consumables needed for its non-invasive treatment, such as serums, boosters, and others. In the most recent quarter, consumables sales jumped 34% y/y, accelerating from a 21% y/y growth in the previous quarter. This is a sign of strong growth momentum amid a difficult environment for consumers.

The strong demand is driven by the growing popularity of Hydrafacial, which is partly due to glowing online reviews. Based on 175 recent ratings, 98% of customers say the treatment is worth it. Companies in the aesthetics space rely heavily on positive reviews to grow, and SKIN's near-perfect review ratings can help the company grow organically.

The company also benefits from powerful macro tailwinds, such as a societal shift towards health and wellness, the post-pandemic Zoom boom, and the rapidly growing aesthetician community. According to estimates, skincare specialists are expected to grow 29% by 2030, making it one of the fastest-growing jobs of this decade. SKIN is well-positioned to be one of the biggest beneficiaries of these positive macro tailwinds, given its growing popularity and the effectiveness of the Hydrafacial treatment.

Yet, the company is facing short-term disruptions due to the challenging macro backdrop and some system issues. Last year, SKIN launched Syndeo, its new-generation delivery system. These new systems have some technical issues, and SKIN is planning to fix them for free, resulting in unexpected one-time costs this year.

The high-interest rate environment is also making it difficult for small estheticians to obtain financing, negatively impacting SKIN's growth in the near term. Instead of buying the new system, many providers opt for refurbished systems or the Allegro system, a new entry-level Hydrafacial system that targets providers who can't afford the flagship Syndeo system. In Q2, many aestheticians opted for the entry-level device due to the high-interest rate environment, negatively impacting SKIN's growth.

Rapid Growth And Improved Efficiencies

SKIN is currently facing margin pressures due to the technical issues of the Syndeo systems and the increased demand for lower-margin refurbished devices. This is why the adjusted gross margin fell to 64.8% in Q2, from 71% in the year-ago quarter. Yet the gross margin pressure is a temporary issue. In fact, on the most recent earnings call the CEO emphasized that gross margins will return to historical levels by the middle of next year.

Also, as we saw above, the company is facing growth challenges within its provider base due to the tight credit environment. In Q2, revenue in the Americas region dropped 16% y/y to $63.6 million, primarily due to a slump in trade-up volume. This time last year, SKIN launched its new Syndeo system in the US, generating $23.3 million in system sales in a single quarter. However, in Q2 of 2023, trade-ups generated only $2.1 million in revenue. This decline is a combination of very tough year-on-year comps and the impact of high interest rates that forced many providers to opt for more affordable alternatives. Excluding the impact of trade-ups, US revenue grew by 18% year-on-year in Q2.

Other regions, particularly Asia-Pacific (APAC), are experiencing much faster growth than the US, thanks to the easing of pandemic restrictions. Sales in the APAC region surged by 143% y/y in Q2 to $25.2 million, driven by strong demand from both providers and customers. This region has even outpaced Europe-Middle East (EMEA), which is also experiencing rapid growth. EMEA revenue leaped by 61% y/y in Q2 to $28.6 million.

This rapid growth is expected to continue for the foreseeable future since the addressable market remains largely untapped. As of Q2, SKIN had an installed base of 29.7K, up 29% y/y. The company estimates that it has the potential to install over 444K devices, indicating that its current market penetration is still in the mid-single digits. In fact, the hyper-growth in Asia underscores the massive market opportunity that can support the company's growth for years.

Despite the gross margin pressures, SKIN capitalizes on its scale, achieving operational and marketing leverage. In Q2, sales and marketing expenses dropped 4.4% y/y to $43 million, while total revenue grew 13% over the same period. This underscores the company's effective marketing leverage. Lower marketing expenses allowed the company to improve its adjusted profit margin to 15.1% in Q2, up from 14.1% a year ago, which is an exceptional performance considering the margin pressures.

What About Valuation

SKIN stock has fallen dramatically in recent months due to margin pressures and internal financial management issues. As you can see below, it currently trades at an all-time low PS ratio of 2.3x. This valuation is undeniably low, considering that all of SKIN's challenges are short-term in nature. In its most recent earnings report, the company reaffirmed its 2025 revenue target of at least $600 million and adjusted EBITDA of at least 25%.

In other words, the company's long-term growth and profitability prospects remain unchanged, meaning that the current all-time low valuation presents an attractive entry point. Assuming the PS ratio rises to 3.5x by the end of the year, SKIN stock can rise by 86% to reach $12.1.

What Else

SKIN's stock is heavily shorted, with a short interest of around 23%, meaning that one out of every four stocks is sold short. This is likely due to the company's relatively high debt of $736 million in the form of convertible senior notes. This type of debt can be converted into equity if the stock price exceeds a certain level at maturity. In SKIN's case, the convertible notes mature on April 1, 2026. If the stock price exceeds $31.76 per share, which is the strike price, the debt can be converted into equity. If the stock price remains below this level, the company will need to repay the principal amount plus interest.

Short sellers are betting that SKIN's stock price won't increase by 370% from its current levels to reach the strike price by April 2026. In such a scenario, the company might face challenges repaying the debt without raising new debt or issuing stock. While this is indeed a real risk, it's still too early to be overly concerned about the debt issue. The most crucial factor is that the company continues to grow rapidly and profitably, and the stock price will ultimately follow the trajectory of the underlying fundamentals.

BEAUTY HEALTH CO. RATING

Short Term: Buy‌‌Long Term: Buy

🎯 12-Month Price Target: $24.40 ➡️ $12.10

I've no positions in the stocks mentioned.

The boring Disclosures: Newsletters express the opinion of the authors. Nothing in this email is a buy or sell recommendation. I'm not a financial advisor; make your own decisions.