Tuesday, 4 March 2014

In Bed with SomnoMed (ASX:SOM)

SomnoMed (ASX:SOM) is an emerging Australian company focused on the treatment of Obstructive Sleep Apnoea (OSA).  SOM manufactures and distributes Mandibular Advancement Splits (MAS). MAS, an Oral Appliance (OA) is essentially a mouth guard that is worn over the teeth during sleep, allowing the airway to remain open. 

So what is Obstructive Sleep Apnoea?

It is the narrowing or total closure of the airway during sleep, causing breathing to temporarily stop. The lack of oxygen is detected by the brain, resulting in an arousal to breathe. Depending on the severity, episodes can occur very frequently throughout the night, resulting in a lack of sufficient rest and has been linked to several health conditions including high blood pressure, stroke, heart failure and diabetes.

Market Potential

One of the first questions I look at when analysing a company like SOM is what is the market potential of the company's product/service and what is the degree to which that market has been penetrated. Basically, I want to know if this company can achieve above average top line growth for several years. The second question is what risks are there that it may not achieve a stated top line growth i.e. has the product been proven, who are the main competitors and how is the company's product differentiated?

SomnoMed rates strongly on both questions. Firstly, the market is significant and is relatively immature. It is estimated that approximately 1 in every 5 adults has mild OSA and 1 in every 15 adults has moderate to severe OSA. The vast majority of OSA sufferers however remain undiagnosed. Yet, of those diagnosed, approximately 60% of patients remain untreated. The growth of the industry will be supported as increased awareness is sought by SOM, competitors and health foundations. Further, health conditions associated with OSA (diabetes and obesity) are on the rise, leading to an increased amount of OSA sufferers.

The traditional form of treatment for OSA has been Continuous Positive Airway Pressure (CPAP), which has been in existence since the 1980s. There are three main competitors that manufacture CPAP devices: Resmed, Fisher & Paykel Healthcare and Respironics (owned by Philips). CPAP works to prevent obstruction of the airway by pneumatically splinting the upper airway open by applying continuous positive air pressure through the use of a nose mask and flow generator. CPAP has been proven to be the most effective treatment method for OSA, however it does have its drawbacks. Patients treated with CPAP often report the method as being invasive and report feeling claustrophobic. The method is also a higher cost than OA and can also be onerous to travel with.  Patient compliance rates are often reported as being in the range of around 50%. Meaning half of those prescribed to use CPAP either stop using the device or use it inadequately, presumably for the reasons outlined above.

This is where SomnoMed's product comes in. The SomnoDent is mostly used as a second line treatment and is often sought by patients who have tried CPAP and were unable to proceed with the treatment (compliance rates are reported at over 90%). Oral Appliances are most suitable for patients who have either a mild or moderate form of OSA, however a recent study has shown the SomnoDent to be also effective in severe cases of OSA. The market as a second line treatment is large in its own right and the investment thesis isn't predicated on OA overtaking CPAP. As an aside however, OA has become a first line treatment in Sweden and Holland. Given the less invasive nature and higher compliance rates it seems logical that OA will be provided as a first line treatment in other countries.

The SomnoDent appears to have been accepted by the medical community and the use of OA has shown to be a successful method in treating OSA in clinical studies. 

How the SomnoDent Works



The two main competitors in the OA market are Resmed (who produce the Resmed Narval) and TAP. TAP (the Thornton Adjustable Positioner) is one of the early adopters of OA. They claim to have sold around 300,000 units, around double the amount SOM have sold. I don't see the competition as being an overly significant threat to SOM for a few reasons. Firstly, the OA market is quite fragmented and there is no competitor that is overly dominant. Resmed's Narval distribution has primarily focused on Europe (although is now being rolled out in the US).  Indeed Resmed entering the OA market further justifies it as an alternative to CPAP. Secondly, the threat of competition is somewhat mitigated by the size of the market. Increased awareness towards Oral Appliances as a treatment for OSA is being aided by competitors. The benefit of increased awareness is likely greater than the competitive threat due to the size of the market. Thirdly, SOM have been reinvesting in their distribution networks to increase their competitive position.


SOM distributes its products to over 22 countries either via a direct method or through a third party distributor. In FY 2013 SOM made four acquisitions in Europe to expand their manufacturing and distribution capabilities.

Oral Appliances are typically sold to OSA patients by Dentists, however patients are usually diagnosed with having OSA through a sleep specialist. SomnoMed has established the SomnoMed Dental Network, which is a network that dentists pay to join, receiving access to discounts, marketing material, patient referrals and contact with sleep specialists. The network in the US now has approximately 2,500 members, which represents around 1.3% of professionally active dentists according to the American Dental Association (based on 2009 data). SomnoMed is working with medical specialists to increase referrals to Dentists in the Dental Network.

The growth potential is evident when looking at the low penetration rate in the US and low current unit sales per network member. In FY 2013, 20,429 units were sold in the US, equating to 8.2 unit sales per year, per member.  Dentists make decent margins on prescribing the SomnoDent and are therefore incentivised to use the product. For example, the SomnoDent cost to dentists is approximately $500 per unit. The typical cost to the patient is around $1,500-$2,500 with the unit cost bundled with the cost of the service. 

Financial Analysis

Unit sales have risen strongly with sales of over 11,000 units in Q2 FY 2014 compared to 2,599 in Q1 FY 2009. Unit sale growth in FY 2010, 2011, 2012 and 2013 has been 60%, 29%, 23% and 16%, respectively. In FY 2013 the company sold 35,841 units and generated sales of $18.5m. Management have provided unit sale and earnings guidance of at least 43,000 and $25m for FY 2014, respectively. Assuming the guidance is met, the figures imply annual growth rates of 20% and 35%, respectively.

In my analysis I've presumed unit sale growth can sustain a level of around 20% for five years and steadily decline thereafter. The growth rate appears feasible based on historic growth rates, low current penetration rates and as the benefits of reinvestment made into sales and distribution  materialises.

Over the last three years, SOM have averaged a gross margin of 67%. Expenses currently make up a large proportion of revenues due to the emerging nature of the business and as initial profits are reinvested in the business to provide future growth. Consequently, EBIT and NPAT margins in FY 2013 were 1.7% and 3.8%, respectively (a tax benefit resulted in a higher NPAT margin). S,G&A expenses were approximately 47% and 49% of revenues in FY 2012 and FY 2013, respectively. As the company matures, these percentages are likely to normalise, perhaps reaching something in the range of Resmed's S,G&A of 28% of revenues. 

SOM have a strong balance with no debt. 


What the results could look like in 5 years' time.

Of course, this will depend on what growth assumptions you use, however I believe these to be achievable.

         Low Case    Base Case     High Case
2019 Projected Earnings $7,014,818 $9,700,087 $12,515,182
Multiple               17.5              17.5             17.5
Implied Value in 2019 $122,759,322 $169,751,522 $219,015,683
Implied Value in 2019 per share $2.74 $3.80 $4.90
Discount Rate 14% 14% 14%
PV of Implied Value $63,757,345 $88,163,621 $113,749,883
Per Share Value $1.43 $1.97 $2.54
Upside/Downside 9.66% 51.64% 95.65%

SOM is currently trading at $1.30 (as of January 2014) equating to a market cap of around $60m.  Not exactly cheap considering revenues of $18.5m and earnings of $700k in FY 2013. However, I believe SOM has the potential to become a major competitor in the OSA space as it gains further acceptance and builds out its distribution network. Based on multiple analysis and my DCF model I believe the current price is attractive enough to establish a position and subsequently purchased shares at $1.35.

Note: The information contained in this post is for my own purposes only.  The post should not be confused with an investment recommendation and details should not be relied upon.

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