Somanetics: Medical Technology Company Worth Monitoring

by: Alan Brochstein, CFA

Somanetics (SMTS-OLD) (14.02, $169mm), the tiny manufacturer of a non-invasive patient monitoring system that measures oxygen levels in the brain and other vital organs, made news this week when it filed suit against an even tinier want-to-be competitor, CAS Medical (NASDAQ:CASM). I have been amazed at how cheaply SMTS has been trading. Could this patent infringement suit serve as a potential catalyst?

SMTS, which I own in a portfolio I manage as well as in my Top 20 Model Portfolio, is a neat little company. It sells the INVOS system (In Vivo Optical Spectroscopy), which consists of a monitor (razor) and sensors (blades). The primary markets are for cardiac surgery as well as neonatal and pediatric surgeries, none of which are elective. It fits a theme that I have been pursuing (MedTech companies with high recurring revenue), and I first got involved with after they reported in June. The stock has fallen about 15% since then despite an overall strong market, so I have been checking my assumptions.

One of the things that caught my attention is how much published research supports this technology, especially in the initial focus area of adult cardiac surgeries. Additionally, I view the company as very aligned with the potential changes in our healthcare system. Use of INVOS makes a lot of sense from a cost-benefit view, as it prevents catastrophes such as strokes, the need for ventilation and costly extended hospital stays.

The company has placed over 2700 systems in 750 hospitals in the U.S. and another 1200 world-wide (where it partners with Edwards Lifesciences (NYSE:EW) in Japan and Covidien (COV) in Europe). While you might think that the business has been bad, sales (all organic) grew 14% over the past year. Not surprisingly, new system placements have stalled, as capital equipment purchases have been slow across the entire hospital universe. In the past quarter, overall sales fell 7% from a year ago, but the consumables grew. System sales in North America plunged 76%, while sensors units increased over 11%, signifying continued use by existing customers but delays in new implementations. The company traditionally gets over 2/3 of its sales from sensors. It adjusted its outlook for the year slightly lower. If it hits its guidance, it will still grow sales by 5% this year despite the tough environment.

SMTS is essentially a monopoly: Hospitals buy its "insurance" or risk negative outcomes. Gross margins have been running in the mid/upper 80s and were still 86% despite the short-fall last quarter. While it is easy to get caught up in the short-term negatives of a tough selling environment, I believe investors may have overlooked the extension of the Covidien relationship as well as some improved labeling, both of which should help drive sales growth in the future. Additionally, the company will be rolling out a new product that it acquired (and which has been depressing earnings as it has been under development) that could really enhance its overall value proposition. Vital Sync, which will tie in both its own INVOS as well as other sources of data, will provide doctors with a single view in order to monitor patients.

CEO Bruce Barrett has been with the company since 1994 and owns about 5% of the company. I like the skin-in-the-game that this former Abbott (NYSE:ABT) exec and his Board/management team exhibit (12% of the company). Further, I find the stock extremely inexpensive. With almost 1/2 the market cap in cash and investments, it is even cheaper than it appears. The stock trades at 18.5X 2010 estimates, which rise sharply as revenue growth resumes and the Vital Sync spending as well as some other short-term projects tail off. The chart below () shows how cheap the stock is relative to its history on several metrics. The Enterprise Value ratios account for most, but not all, of the cash, as the company maintains LT cash that isn't included in the calculation. Note that the company has total liabilities of just $2mm. Further, over 80% of the assets are cash/investments,with only $2mm in intangibles, $3mm in net PPE and $11mm in AR and Inventory. Balance sheets don't get much better than this!

SMTS Valuation

While the company might have another challenging quarter, it is difficult to imagine new placements getting much worse for much longer given that they are down 56% in the first half of the year. Most likely, the consumables will continue to grow at double-digit rates, which is important given their high representation in the mix. I think that the company could become an acquisition candidate given its unique technology and its wad of cash. The expense structure is quite high - it would be easy for a larger acquirer (perhaps one of its international distribution partners or another company that sells to hospitals) to cut some of the SG&A. While I think that potential offers some downside protection, I am optimistic that the market will begin to value the company significantly higher later this year when the system placements begin to reaccelerate.

I believe that the stock could double over the next 15 months. My year-end target for 2010 is that the PE reaches 20 and the company is credited for its cash of $6 per share. The current consensus of 1.03 for fiscal 2011 (3 analysts) may be a little low (range is .90-1.19 and I independently calculate 1.15), but that would give a price of 27 (20.60 plus the cash, which should grow over the next year). I had expected the stock to hold the 14 area, but it briefly failed. The chart () isn't as clearly positive as I would like to see, but that could certainly change quickly. Until then, I think that this is a value play waiting for growth to reemerge.

SMTS chart

Disclosure: Long SMTS