SomnoMed: Result 2018

SomnoMed increased revenue 29% to $64m compared to last year, including a 10% rise in its core business selling custom-made mouthguards for the treatment of sleep apnea, as well as an $11m contribution from the new Renew Sleep Solutions (RSS) network of sleep clinics that sell directly to patients using in-house dentists. 

Operating profits, on the other hand, were lousy. The company's core business earned $3.9m of earnings before interest, tax, depreciation and amortisation (EBITDA), but this was entirely offset by a $10.4m loss from the sleep clinics, so overall EBITDA was a loss of $6.5m. The result had no real surprises, with the company having released its unaudited accounts last month.

We've been wary of the new RSS business model from the get-go, and have increasingly lost our patience with the company and management. SomnoMed is now competing with its own distributors and sales have slowed materially in the US due many dentists leaving the SomnoMed network due to the conflict between their own sales and RSS. General administration and marketing costs have been rising as a proportion of sales, the cost of acquiring new customers is increasing, the RSS model is far more capital intensive than a simple manufacturing model, sales at the RSS centres have been slower than expected … the list goes on.

As we have explained previously, if the RSS centres continue to perform poorly then the company's $13m of cash won't last more than a couple of years. That would force SomnoMed to raise capital or take on a big wad of debt. Management has reduced its expansion plans from 12 cities to eight, so the cash bleed should slow, but with the second cohort of centres performing worse than the first, we think another capital raising is still likely. 

Management expects the core business to increase revenue by 15% in 2019 and for RSS revenue to grow by 25–35%. EBITDA of $5m–5.5m from the core business, however, is likely to be completely offset by a forecast $5m–6m loss at RSS.

SomnoMed's share price has fallen 19% since we downgraded to Sell in Letting go of SomnoMed on 26 Jul 18 (Sell – $2.42). The stock currently trades on a price-earnings multiple of 10–17 based on our (wide) range of forecasts for 2020 earnings (as explained in last month's downgrade). The bottom end of that valuation range doesn't look expensive, but we don't think it's worth the risk – if RSS turns out to be a dud, it could easily wipe out any chance of profits in 2020 and would likely force another dilutive capital raising.

Given the increasing risks, it's hard to pin down a price at which we'd be happy to buy the stock again. We're glad we got out when we did, locking in a 14% annual return. With a current market cap of only $122m or so, it's time to move on to bigger and better opportunities. CEASING COVERAGE.