Somnomed -SOM 16/2/11

SomnoMed

Share Price: $1.03

Market cap: $43,280,864

Cash: $3,750,000

No. of Shares: 42,020,256

Target Price: $1.46 (41% discount)

Products-


1. SomnoDent *gold standard (patented/clinically proven/compliant) (FDA, TGA, CE, ISO 13485, Swiss Medic)

· SomnoMed manufactures mouthguards (mandibular advancement splints (MAS)) that are worn over the teeth during sleep for patients who are in need of a treatment for obstructive sleep apnoea (OSA) and other sleep disorders. It has a success rate of 50-70% & compliance of >90%.

· Until recently the OSA market has been used as a second line therapy for patients who are intolerant of CPAP therapy.

· CPAP – A flow generator is used to push air through a tube and mask and into the nose and throat

Advantages:

o 100% effective

Disadvantages include:

o Compliance <50%

o Discomfort/ noise level/ inconvenience during travel

Notable companies in the CPAP market – Resmed – Philips (Respironics) –Fisher & Paykel

Resmed – $1,092 billion revenue in FY10

Philips – 23 billion Euros revenue in CY09

Fisher & Paykel – $322.1m revenue in FY10

· However note the OSA market is still in a development phase and is only a fraction of the total sleep disorder market. Somnomed approximates that its market share is approximately 30-40% of the OSA market.

· The OSA market is only a fraction of the total sleep disorder market because 1. The first devices to emerge did not have an evidence base 2. No efforts were made to provide the infrastructure to build a marketplace.

2. SomnoBrux – A new product launched in 3Q10 which treats sleep bruxim, that is the grinding and clenching of a patient’s teeth during sleep

Potential Growth


· Somnomed has a strong market position with recognized brands and reputation for clinical excellence and quality.

· Dentists ultimately pay Somnomed for their MAS devices (c. $500 – $600 each) and bundle this with the overall cost for providing the service ($1,500 – $3,000)

· Somnomed can support revenue growth by attracting more dentists or sleep physicians into their network.

· Currently have 3,000 dentists in its network. 1,700 of which are from the USA which only accounts for 1% of the number of dentists in the USA.

· 6 full time sales representatives in the US

· Utilization rate is currently only about 0.8 devices/dentist/month

· 3,000 x 0.8 x 12months = 28,800 devices a year (guidance for FY11)

· A small minority of very active practices prescribe 30-40 devices per month. The company pitches the revenue opportunity to dentists at an expected ‘average’ rate of 10 devices per month.

· SOM outsources much of its manufacturing to dental laboratories. It started its own manufacturing facility in FY10 in the Philippines which accounts for 40% of production.

· Small facilities are located in the USA and Australia

· CEO Ralf Barschow has relocated to the U.S to focus on driving sales in the region.

· The company has achieved 60% gross margin in their latest quarterly report but have publicly mentioned that 70% may be achieved with more cost savings through the use of their Asian laboratories as volumes increase.

· They retain guidance of 28,000 units for FY11 and 36,000 units for FY12. This implies a 43% & 29% growth respectively.

 

MAS Devices reimbursement


· Australia (16%)- Medicare does not cover the cost of CPAP or MAS treatments.

· Europe (16%)- Most European countries offer public insurance reimbursement of dental services.

· Sweden- Recommend oral application as the first line of treatment. CPAP is recommended if the patient is unwilling to use an oral application. The cost of the OA treatment is fully covered by the Swedish healthcare system.

· Netherlands and France recognize oral appliances as a first line therapy for OSA.

· Germany- Expect a release on their reimbursement policy in 2011.

· USA (68%)- Reimbursement for non-Medicare patients is available but claims are most often submitted to medical plans than to dental plans. Also reimbursement for oral appliances are only accepted to patients that are officially diagnosed with OSA through overnight polysomnography.

· US Medicare (>65 yrs) does cover oral appliances when it is billed on E0486 (oral device/appliance used to reduce airway collapsibility). The management and evaluation services must be billed separately under Medicare Part B. In the past general dentists have had trouble receiving reimbursements for the oral appliances as some carriers refused to contract with general dentists. Recent changes in US Medicare policy in Dec-2010 however now allows general dentists to sign up as carriers and receive payment for their services under Part B AND payment for the device under DME POS E0486.

The new policy states:

· Therapy for the treatment of OSA is covered without the precondition that the patient is deemed unsuitable for CPAP treatment.

· Only custom fabricated mandibular advancement splints (MAS), which INCLUDES SomnoDent, are covered. Other non custom appliances are deemed medically unnecessary.

· As a result it is expected more dentists will now offer oral devices for their Medicare patients.

· It is estimated the US Medicare program covers 15% or around 50 million Americans.

Approximately 20% of the US CPAP market are noted as Medicare beneficiaries account and WILSONS expects that this will be true for the oral appliance market as well.

· Also those on private health insurance, ~ $200 million Americans (52% employer-sponsored insurance), will see the recent policy changes as a precedent to accept the use of oral appliance treatment as a first option without the use of CPAP.

Notable Competitors out of dozens-


Resmed’s ORM Device-

· Acquired the Narval ORM device in 2009. Similarly to the SomnoDent the device also claims to allow their patients to speak, drink, yawn and have minimal bulk. RMD uses a computer aided design (CAD) technology which then uses the digital data to fuse the three-dimensional shape into a plastic device. Generally the plastic material lacks the rigidity of acrylic (SomnoDent) which could be a possible disadvantage. However dentists usually have a preference for one or the other.

· RMD currently only sell their devices in parts of Europe and Canada, NOT in the USA.

TAP3-

· Thorton Adjustable Positioner (TAP) is a notable competitor with 7,000 prescribing dentists worldwide in both Europe and USA vs. 3,000 in SOM’s network. TAP3 is a new design that allows complete lip closure. The TAP locking mechasnism is commercialized by Airway Management Inc and sold to dental laboratories to fabricate a device. The quality standard of each device cannot be controlled which is a significant disadvantage. The product is widely available.

Catalysts-

· The OSA market is still developing and there is significant growth potential with RMD estimating that only 10% of OSA sufferers have been diagnosed.

· SOM have announced that they intend to launch an upgraded version of the SomnoDent MAS in 1H12.

· Possible news out of Germany on their reimbursement policy of oral applications in the treatment of sleep disorders.

· U.S private health insurers will look to take their lead from Medicare which will gradually increase the coverage of oral applications used as a treatment for sleep disorders.

Risks -

· RMD enters the USA market with their device and other notable competitors ramp up their distribution dampening the demand for SomnoDent.

· SOM’s position as a market leader may be threatened by the release of a superceding product. The current success rate in treating OSA with SomnoDent is 50-70%.

· SOM’s sales are made offshore therefore is subject to exchange fluctuations.

Conclusion-

· SOM is currently trading on a PE of 14x and is cash-flow positive with a cash balance of $3.75m and ~$4m in tax losses. Somnomed generated $230,000 in net operating cash in the latest quarterly report (31st December 2010)

· Using a discount rate of 15%, growth rate of 29% beyond FY12 to FY19 (patent expiry) and gross margin of 60% I arrived at my target price of $1.46. These numbers I believe are conservative given the strong growth SOM has had in the past, a 71% increase in unit sales in FY 08/09 and a 63% increase in FY 09/10. Also the product is the gold standard and is the current market leader. These numbers have also not factored in Somnobrux sales which was launched in 3Q10 and have sold >2,000 thus far.

· In the latest quarterly commentary the company stated that it had no plans to raise any additional capital. However I believe due to the recent Medicare policy changes in the US and the increasing threat of competitors taking market share, SOM will be required to raise additional capital to secure future growth and market opportunities. The market seems to be anticipating a highly dilutive raise which may have kept the share price in its current trading band.

· The recent relocation of current CEO Ralf Barschow to the US is a step in the right direction given it accounts for 68% of SOM’s revenue and will be key in gaining better traction in the market.

· Rating: HOLD – While the fundamentals remain cheap, there are not any real strong catalysts that will drive the share price. Also there are a number of notable competitors (RMD) with deep pockets which is a cause for concern and questions whether SOM’s revenue and growth is sustainable over their patent life period.

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