The Beauty of Lasers

Beauty may only be skin deep, but that's all aesthetic laser companies need. Whether you want to remove unwanted hair, smooth out wrinkles, obliterate spider veins, or erase "Tasha Forever" from that impulse tattoo, there's a laser for the job.

That job is big business now. According to CIBC World Markets, the cosmetic laser market is valued at about $1 billion worldwide, and sales grew 15% in 2006 over the previous year. While hair removal remains the top use of cosmetic lasers, with growing numbers of non-core markets acquiring them -- hospitals, family practitioners, OB/GYNs, and even spas and beauty salons -- additional uses will continue to climb in importance.

Investing in the future
Competition is particularly cutthroat and research and development continues to play a central role in which company remains dominant. Based on revenues, Candela (NASDAQ:CLZR), which says it created the aesthetic laser market, is top dog with $154.5 million in sales at the end of 2006, followed closely by Palomar Medical Technologies (NASDAQ:PMTI). On a market valuation basis, however, Candela is actually at the bottom of the heap, with its shares declining in value from numerous earnings misses.

The power of ideas
A company's intellectual property remains its best defense against losing superiority. Once it turned profitable, Palomar had the wherewithal to defend its patents, and it began notifying the industry of violations. It demanded -- and ultimately received -- licensing agreements and royalties from many rivals, including Cutera, Lumenis, and most recently privately-held Alma Lasers.

It's also lined up a licensing agreement with Procter & Gamble's (NYSE:PG) Gillette for the manufacture of a home-use device -- as has Syneron -- and another with Johnson & Johnson (NYSE:JNJ), though both are still years away from being mass marketed.

Unlike its peers, Candela has chosen not to pay up, instead countersuin on charging that Palomar has infringed on Candela's patent portfolio. In a bit of jury-shopping, it's filed lawsuits in both Massachusetts (where both it and Palomar are based) and in the eastern district of Texas, which has a reputation of siding with patentholders.

Operating in the margins
While the drama is fascinating, which company is really the better investment? Let's look at operating margins, since fatter margins generally mean fatter profits.

While Candela has long been an industry leader, it long ago lost its grip, supplanted by other, more innovative companies. We see that both Syneron and Palomar have become the dominant forces in the industry. Although Syneron has been a force to be reckoned with since its IPO in 2004, I think Palomar is the one to watch here.

In terms of margins, it's still behind Syneron, but well ahead of the competition. And Palomar continues to grow more profitable by the year. Depending upon the metrics you look at, it can be viewed as either richly valued, or significantly discounted.

A leader emerges
I prefer to focus on Palomar's price-to-earnings ratio, which makes the stock look considerably undervalued. Revenues continue to grow and profits have been strong. Palomar has wrangled concessions from its competitors for its patents, and it may do so again from Candela, though that is far from assured. Palomar is an innovative company with industry-leading products in most areas of the aesthetic laser market. With the potential for expanding its lasers into the home through a $1.5 billion collaboration with Gillette, Palomar may get the chance to supplant Syneron as the margin leader.

Palomar's shares have fallen by nearly one-third over the past two months, on fears of flattening sales. Yet if we consider the potential to bolster laser sales with a steady stream of revenues from royalty payments, Palomar could look attractively priced. There's a definite risk, however, that Candela will prevail in the patent legal volley. A Candela victory would leave Palomar owing money to its rival, and take companies it previously beat into submission off the hook for making future royalty payments.

Either way, any such outcome is years away. In the interim, I think Palomar can be a winning investment.

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Fool contributor Rich Duprey owns shares of Candela but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.