SomnoMed's shifting business model

SomnoMed is an expert at detours. A few years ago the company started sharpening a direct sales model so it could bypass the low-margin licensing of its SomnoDent device to third parties.

The company also avoids sleep specialists – the usual gatekeepers to sleep apnea therapies – by encouraging dentists to actively diagnose patients and fit them with SomnoMed products.

Now the company wants to sell to patients directly, and has plans to open sleep clinics under licence from US-based Simple Sleep Services (known as S3), an existing provider in Texas. The sleep centres will advertise to potential customers, help with insurance reimbursements, and use in-house dentists to diagnose patients and fit the mouthguards.

The new subsidiary will be known as Sleep Centres America and S3 will get a 16% stake and act as an advisor. SomnoMed won't pay anything for the brand licence; however, it will pick up the tab for the fitout cost to build each centre, which is expected to be around $500,000.

Management has outlined a pretty rosy picture when it comes to the profitability of the new centres. The company expects around 1,650 patients per centre after three years, which will bring in around $4m of revenue and $1.2m of operating earnings – a 30% margin.

SomnoMed plans to open five new centres in 2017 and 10 more in 2018, so revenue might double over the next couple of years – and this says nothing of sales through its existing network of aligned dentists. Direct sales grew 21% as of the most recent quarterly result.

Still, we have our concerns. The revenue and profitability forecast is based on just two centres currently operated by S3. Those centres are both based in Texas, and SomnoMed's licence is for every state other than Texas. We have no reason to doubt management's forecasts, but the strategy has risk.

Operating clinics is a very different beast to selling mouthguards to dentists. Management has barely put a foot wrong building the business to where it is today, but who knows if its skills are transferable to this new business model.   

Entitlement offer

The company has announced a $10.5m capital raising to fund the new venture, giving existing shareholders the option to buy two new shares at $2.50 each for every 25 shares already owned.

Unfortunately, the offer is non-renounceable so you can't sell your entitlement on the open market. If you are unable or unwilling to take up the offer, the intrinsic value of your holding will fall by around 7%. This 'use it or lose it' condition isn't fair. Renounceable offers, which allow you to sell your entitlement on the market, are our preferred way for companies to raise capital.

A non-renounceable offer is bad enough, but we are also disappointed to see the company giving preferential treatment to a single institutional shareholder – TDM Asset Management, which owns around 5% of the stock.

TDM has agreed to subscribe for any leftover entitlements, and so will cover any shortfall to management's $10.5m target. To reward this generosity – a choice unavailable to everyone else – TDM is being granted 400,000 options at a strike price of $3.00 per share.

The entitlement offer closes on 27 May. On valuation grounds alone, we're closer to selling the stock than buying so we don't recommend members subscribe to increase their holding. However, with the offer price at a 10% discount to the previous closing share price there may still be value on the table.

If you already own, say, 10,000 SomnoMed shares, you could sell 800 shares (2/25 of your holding) on the market for proceeds of $2,240 (800 X the current share price of $2.80). You could then use those proceeds to subscribe for 800 new shares through the entitlement offer at the lower price of $2.50. After the offer's completion, you will have the same number of shares you started with, but an extra $240 in your pocket (800 X [$2.80 – $2.50]).

For small shareholdings, that little manoeuvre may not be worth the effort involved, especially once brokerage is taken into account, and it also depends on the share price remaining above the offer price when the stock's trading halt is lifted on 5 May.

The other '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). Selling may crystallise a capital gain so you should consider your personal tax situation first and seek professional advice if you are unsure of the tax consequences.

Time to take profits?

SomnoMed's business is growing rapidly. Management expects revenue to rise by around 30% in 2016 to $44–45m, with operating earnings expected to increase by around 150%. However, it is still a speculative recommendation, and there's no getting around the fact that running sleep clinics is a significant and untested shift in SomnoMed's business model.

In these situations, we prefer to focus on risk management rather than try to value the company with inevitably false precision. We're going to take the same approach that we've adopted for other fast growing minnows, such as Nanosonics, by throwing away the price guide and using the portfolio limit to guide our recommendation.

We're happy to hold SomnoMed for the long term 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 the company hit any speed bumps. HOLD.