SomnoMed: Growth at any cost?

Financial journalists like to style 'value' and 'growth' investors as opponents battling for intellectual supremacy.

In reality, growth is an ever-present component of a company's value. What counts, though, isn't how quickly the company is growing. Indeed, growth can even detract from value if management is spending on unprofitable initiatives. The only thing that matters is how much cash you hand over today, how much you're going to get back, and when that will be.

Since its founding in 2004, dental appliance maker SomnoMed hasn't produced a cent of free cash flow. Most companies try to throw off cash – SomnoMed sucks it in. In fact, if you add up all the money the company has ever made, then deduct all the funding handed to it, shareholders are still about $16m in the red.

For most businesses, a lack of free cash flow is a red flag, but for SomnoMed we find it a comfort. Cutting costs to increase profits or – worse – pay a dividend is the last thing we want management to do.

SomnoMed is past the costly research and development stage and now has a commercial product – SomnoDent, a custom-made 'oral appliance' for the treatment of mild obstructive sleep apnea (see SomnoMed: A future mini-ResMed). Now, management's task is to get it in front of customers and build the brand.

Marketing spend

That's why we're delighted to see the company spending a hearty 28% of revenue on sales and marketing.

The trouble is that marketing costs flow through the profit and loss account as equally as, say, SomnoMed's cost of materials. Marketing detracts immediately from net profit, but, while still a real cost, it should also build value. Most companies rightfully try to lower their cost of production as much as possible, but that's not the right approach when it comes to marketing. The scoreboard to watch is return on investment.

SomnoMed's sales and marketing expenses have risen from $2.5m to $9.5m over the past five years, but it's been money well spent. Unit sales have more than doubled over the same period, while revenue and gross profit have tripled.

SomnoMed increased its sales and marketing expenditure by $1.8m in 2015, but that helped add $4.2m to revenue and $2.7m to gross profit. So long as a dollar of marketing spend is creating more than a dollar of value, the company should continue investing.

When SomnoMed's reputation is well established and the market matures, marketing costs – the theory goes – should decrease as a proportion of revenue and the savings will flow through to the bottom line.

US growth

For now, though, the company is still very much in growth mode. Total unit sales came to 12,846 for the three months to September, an increase of 15% on the prior year. Revenue increased an even more impressive 30%.

The result was propelled by a lower Aussie dollar and a strong US market, where direct unit sales increased 37% despite a significant drop in licensee sales.

'Sales to our licensees in the US and Canada who are dental laboratories making our products … were down by 83%, or over 1,000 units, underlining the diminishing role dental laboratories play and will play in the future in supplying devices to the general dental market. Patients are coming predominantly through the medical referral channel to dentists specialised in dental sleep medicine,' said Chairman Peter Neustadt.

New guidelines

SomnoMed sells its products through a network of 4,000 dentists worldwide, which fit patients with the mouthguards. Historically, the company has encouraged dentists to actively diagnose patients that may be suffering from sleep apnea, rather than wait for a doctor's referral. We don't expect this practice to continue for much longer.

In July, the American Academy of Sleep Medicine and the American Academy of Dental Sleep Medicine unveiled the first joint clinical practice guidelines for the treatment of sleep apnea with dental appliances. The guidelines recommended that a dentist fit a custom oral appliance and provide follow-up care only after a sleep physician prescribes the appliance.

Furthermore, it was said that continuous positive airway pressure (CPAP) treatments – those from the likes of ResMed and Fisher & Paykel Healthcare – are still the most effective treatment for OSA and should be considered the 'first-line' therapy.

While CPAP will likely remain the gold standard, the convenience, low cost and increasing insurance coverage of oral appliances means the market is all but assured to continue to grow. The US is by far SomnoMed's most significant opportunity with patients fitted with oral appliances expected to quadruple to over a million by 2020.

So what's the catch? A rapidly growing market attracts competition and how much of the market SomnoMed can capture is still uncertain. SomnoMed, with around a 10% share, is currently the number two player behind US group Airway Management Inc but there are more than 20 smaller competitors angling for a slice of the pie.

Dentists typically stock several devices and, as their main priority is the patient's individual needs, their loyalty to SomnoMed may be fleeting, especially if a superior product comes along.

Taking profits

The share price has fallen 6% since SomnoMed: Result 2015 from 20 Aug 15 (Hold – $2.65) but is up 86% since we upgraded the stock in SomnoMed: A future mini-ResMed? on 5 Feb 14 (Speculative Buy – $1.33).

Management expects unit sales of 62,000 for the 2016 financial year (up 21%) with revenue of $42m (up 22%). Earnings should get a further boost from the lower Australian dollar as 90% of SomnoMed's revenue is earned overseas.

While SomnoMed has barely put a foot wrong in a decade, it still isn't anywhere near as durable as a ResMed or Fisher & Paykel Healthcare. The stock should only ever represent a per cent or two of your portfolio and we highly recommend taking profits as the share price increases. This will allow you to own shares in a rapidly growing business if everything goes to plan, while ensuring you bank a decent profit should things turn sour. HOLD.