SomnoMed: A future mini-ResMed?

Over the past few years we’ve had much success in finding cheap, high quality companies in the healthcare sector, including ResMed and Fisher & Paykel Healthcare, both of which service the obstructive sleep apnoea (OSA) market.

SomnoMed is another local company that services the same market. It makes and distributes ‘oral appliances’, particularly those that treat patients with OSA [Prepare yourself for an ‘Acronym Rich Review’, or ARR—Ed], but with a twist. It services those patients who can’t or won’t use the products made by the likes of ResMed and F&P Healthcare.

In the United States, around two million people are diagnosed with OSA each year. About 1.7m of those are prescribed the current ‘gold standard’ treatment known as Continuous Positive Airway Pressure (CPAP). A stream of air is pumped into the patient’s airway through a tightly sealed mask attached to an ‘air-flow generator’ (see ResMed: breathe deeply and buy).

With some 46m Americans estimated to suffer from OSA, the vast majority of whom are undiagnosed, this is a huge and growing market. SomnoMed focuses on a small, distinct portion of it – OSA sufferers who find CPAP machines uncomfortable and invasive – leaving the rest to the likes of its bigger brethren.

Of the two million Americans diagnosed each year, about 5% reject CPAP machines in favour of what is known as Mandibular Advancement Splint (MAS) treatment. Of those 100,000 sufferers, about 20% (30% by value) use SomnoDent products made by SomnoMed. In comparison with ResMed and even the much smaller F&P Healthcare, this is a tiddler.

Effective treatment

MAS devices look like elaborate mouthguards (see Image 1), forcing the lower jaw into a more forward position which tightens the soft tissue and muscles of the upper airway. Clinical studies have shown this to be an effective treatment for those with mild or moderate OSA and an alternative for those with severe OSA that reject CPAP treatment.

Image 1

CPAP goliath ResMed entered this market a few years ago, lending some weight to the idea that this type of therapy might have genuine prospects. Questions remain, though. The splints can produce soreness in the jaw and, in some cases, loosening of teeth.

If the devices end up causing harm in too many patients, that would undermine their legitimacy, and the investment case. But Dutch health authorities seem to have got past these concerns. In Holland, MAS devices are prescribed as a first line therapy for those patients with mild or moderate OSA, with the cost fully reimbursed by government.

Lately, SomnoMed has taken to calling its treatment ‘COAT’ (Continuous Open Airway Treatment), perhaps to make it sound more like CPAP. In the four years since Holland backed COAT as a first line therapy, SomnoMed estimates that the CPAP/COAT treatment split has moved from 92/8 to 65/35 and expects a 50/50 ratio will be achieved over the next two years.

This trend has led to significant growth for SomnoMed in Europe with the company pushing into new territories. France is currently the main focus as it recently introduced a favourable reimbursement policy. SomnoMed is also getting traction in places as diverse as South Korea and Israel.

As Chart 1 shows, SomnoMed is growing at quite a pace, and profitably so. In the past five years annual sales units have increased 410%, revenues have grown by 305% (impeded by a stronger Aussie dollar, compared to unit sales) and gross profit by 527%.

With growing acceptability in Europe and elsewhere, COAT seems to have a great deal to offer. Patients don’t need a mask clamped to their faces all night, nor do they have to lug around a machine when travelling, or be connected to a power supply.

If SomnoMed can keep delivering on its growth plan, then it’s feasible that unit sales could double or more over the next four or five years. And that may prove quite conservative.

The company reports quarterly and the latest figures show it’s on track to deliver 20% unit sales growth in 2014. That would equate to around 43,000 units. From there, it doesn’t seem a stretch to imagine more than 75,000 units four years later, in 2018.

Assuming a moderate increase in price per unit due to more advanced technology, we could see SomnoMed producing $50m in revenue in 2018. Table 1 shows how the numbers might break down from there.

Should SomnoMed achieve these numbers it’s easy to imagine it being valued at $150m or more—two and a half times today’s valuation. And the results might well be better if the company’s own higher expectations are met.

So where’s the catch? A growing market like this attracts competition, which could reduce SomnoMed’s profits. Whilst it owns a family of patents there are alternative products on the market. If ResMed, for example, turned a portion of its $120m annual research and development budget to the segment, it could outspend SomnoMed by a huge margin.

At present, that seems unlikely. Oral appliances are such a small percentage of the OSA treatment market (which itself continues to grow at a decent clip) it wouldn’t be worthwhile for the big players to worry about it. But that may change if the portents from Holland ring any bells in other countries.

Biggest advantage

Should that occur, SomnoMed’s biggest advantage would be its global network of more than 4,000 aligned dentists, which take the moulds and fit patients with their oral appliances. The company is now encouraging them to actively diagnose patients that may be suffering from OSA rather than waiting for a referral from a sleep clinic.

In fact, the lack of an established network of dentists seems to be the main reason why ResMed has not made substantial inroads into the market to date. Building such a network is time-consuming and expensive, a fact that would make SomnoMed an attractive takeover target for a larger competitor wanting to enter the segment.

Global market share statistics are difficult to come by but, based on our research, SomnoMed appears to be the number two player behind US group Airway Management Inc. with its Thornton Adjustable Positioner (TAP) product. It claims to be the global leader with over 300,000 units sold worldwide (compared to SomnoMed, currently at just over 150,000) and also has a network of more than 7,000 dentists.

In a fast-growing market like this, there should be room for several strong players, so we don’t believe being number two (or even three) is a problem. In fact, many dentists prefer to stock several devices to better fit their clients’ individual needs. And because each geographic market is distinct, SomnoMed may be able to establish leadership in new countries (as it has done in Holland).

A speculative exception

Still, this remains a speculative play. SomnoMed, which supplies a niche product, with a market capitalisation well below our usual $100m cut-off, is small. But that’s one of the reasons why we’re making an exception for it. Its small size and substantial prospects make explosive growth possible. It’s far easier for a minnow like this to quadruple than it is for a more mature, multi-billion dollar operation.

The risks are as clear as the opportunity. If this were an asset play offering a 50% return in a year or two, we wouldn’t bother highlighting it because it would be too hard to buy in to such a small stock with a view to quickly selling out.

SomnoMed is something different: a global competitor in a growing niche of a large, growing market. It could easily have more than a decade of impressive growth ahead. We wanted to put it on your radar long before it gets big enough for the brokers and big fund managers to start paying attention, but you may need some patience to pick up shares given the relatively low liquidity.

A speculation like this should only ever represent a percentage point or two of your portfolio. But in a world where so much speculation is based on nothing more than a fanciful idea and a prayer, it’s nice to find a little gem with a real product and a growing revenue stream. SPECULATIVE BUY.