SomnoMed, sales growth and false precision

We don't need spectacular growth numbers to buy a stock; a fundamentally strong business with declining sales can still make a respectable investment if bought at a bargain price. Admittedly, though, big green numbers do put a smile on our face, and SomnoMed – the maker of mouthguards that alleviate mild sleep apnea – has given us plenty to smile about.

The final quarter of the financial year was one of the company's strongest yet, with the company selling a record 19,859 units in the three months to June, up 24% compared to the same period last year. Total unit sales for the year came to 68,100, up 15%, with revenue up 12% to $49m.

We were pleased to see quarterly sales growth of 24% in the US, SomnoMed's largest market. Canada helped overall North American sales rise 32%.

Even for a company where double-digit sales growth is the norm, that's a big deal – especially given that US sales declined at December's interim result.

While patients are the end users of SomnoMed's products, the dentists that diagnose and fit the mouthguards are the company's customers. Or at least they were until SomnoMed announced last year that it would also sell directly to patients by opening sleep centres – known as Renew Sleep Solutions (RSS) – that advertise to potential customers and use in-house dentists to diagnose patients.

This, however, has opened up a conflict of interest: SomnoMed is now competing with the distributors that made it successful. The dentists don't like it one bit and some have pulled their support, which is why sales flat-lined at the interim result.

Thankfully, that seems to have been a temporary setback. ‘The reaction of some sleep dentists in the US to the perceived channel conflict with RSS seems to have stabilised and we continue to add new practitioners to our Preferred Dental Network,' said chief executive Derek Smith. Management said that RSS advertising would benefit its 2,500 aligned dentists thanks to improving awareness of oral devices as a treatment for sleep apnea.

The company opened its seventh RSS centre in June – two centres ahead of schedule – and invested $2.2m into the business during the quarter. Another 10 centres are planned for 2018. Management didn't break out the earnings performance of RSS specifically, but we hope to see more detail when the company reports its full-year result in August.

European sales boom

Asia-Pacific sales put a dampner on things, with volumes down 4% due to poor numbers in Korea and Japan. Sales in Australia and New Zealand were down 2%, although they rebounded at the end of the quarter and were up 10% in June.

Unit sales in Europe, however, were up an impressive 21%, with growth particularly strong in Norway, Italy and Spain. Management expects the growth to continue due to some regulatory tailwinds: France and Belgium are both reviewing reimbursement policies for SomnoMed's dental products due to its lower cost and higher compliance relative to competing devices – namely continuous positive airway pressure (CPAP) machines. Improved reimbursement would reduce the out-of-pocket costs for a patient.

The only real stain on the result was that overall unit sales growth of 24% wasn't matched by revenue, which only increased 12% to $14.3m – which implies a 10% fall in the average selling price this quarter. We suspect the culprit may be aggressive pricing at the RSS centres as they establish themselves, or more favourable pricing for dentists to make up for the ‘perceived channel conflict' (by which management means ‘very real conflict').

Investment in marketing

A more convenient ‘problem' is that SomnoMed's share price has more than doubled since we originally upgraded the stock in SomnoMed: A future mini-ResMed? on 5 Feb 14 (Speculative Buy – $1.33). At that time, we made assumptions about what the business might look like in 2018: revenue of $50m, gross profit of $34m, and pre-tax profit of $12m.

The company's growth has beaten our expectations, with the revenue target being met a year early and gross profit not far behind. But pre-tax profit of $12m is a pipe dream – something that rounds to zero in 2017 seems more likely. So where did our $12m go and should we be worried?

The lack of profits is down to one thing: far higher marketing and administrative expenses than we anticipated. However, we doubt SomnoMed would have beaten our revenue target by so much had it not spent heavily on advertising. If marketing and admin expenses were rising as a proportion of sales we might be worried, but they've been steady at around 54%. You could argue they're a necessary up-front investment in future growth.

Over time, we expect these expenses to decline as a proportion of sales due to operating leverage – it shouldn't take twice as many office staff to sell twice as many mouthguards, so more of each additional dollar of revenue should turn to profit. For the time being, however, we're happy to see the company investing more in its brand and the rollout of sleep centres. 

Given the huge potential market and European tailwinds, revenue could double again over the next few years. If, by then, SomnoMed has reduced its administrative and marketing expenditure from 54% of sales to 27% – which is roughly what peers ResMed and F&P Healthcare spend – that could give around $28m of pre-tax profit.

When to sell

With this as a backdrop, today's market cap of $182m suddenly doesn't seem so daunting – and that's the trouble with valuing rapidly growing companies that lack current profits. Pinpointing a sell price is akin to sharpshooting on a windy day – a speedy bullet crossing a long distance will end up in wildly different locations given the slightest breeze. It doesn't take much to value SomnoMed well above where it is today, but experience tells us that things don't always go to plan.

Still, sales targets are being met and the business is building its brand and investing for future growth. The balance sheet looks good, and management seems to be gracefully navigating a change in strategy that should give the company more control and higher margins down the track.

In these situations, it's better to focus on managing risks than to try to nail down a sell price with false precision. SomnoMed doesn't look overvalued, but we highly recommend gradually taking profits to maintain a maximum portfolio weighting of 2%. If everything goes to plan, you'll continue to own a slice of a booming business, while making sure that you bank a respectable profit should SomnoMed's unknowable future turn out less rosy than we expect. HOLD