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Long Case for Somanetics

|Includes: Somanetics Corp. (SMTS)
Somanetics (Nasdaq SMTS) Troy Michigan, is the pioneer and leader of cerebral and somatic (of the body) oximetry, providing U.S. clinicians with the first adult cerebral oximeter, the first pediatric cerebral oximeter and the first simultaneous brain and body oximeter.

Known as the INVOS Cerebral/Somatic Oximeter, this noninvasive patient monitor continuously measures changes in blood oxygen levels in the brain and in the body of patients who are at risk for restricted blood flow so clinicians can detect and correct a variety of threatening complications. Today, the INVOS System is in use at 700+ U.S. hospitals, including 80% of centers performing pediatric cardiac surgery.  They have placed a total of 2,927 monitors worldwide.

I have been following SMTS for 10 years. Today, I feel more confident in purchasing shares then anytime in the past. The INVOS System is being accepted by the medical community as a necessity at a faster clip than at any previous time.

The financial crisis has caused the cost of capital to increase to the point that all businesses including hospitals are hoarding cash. New technology has a harder time getting a piece of the limited capital spending budgets and that has and will continue to effect sales of the INVOS System. However, there is a growing level of pent up demand, which should result in a “catch up quarter” down the road.

Vital Sync System:

The Vital Sync System acquisition makes Somanetics a two-product company answering one of the risks (one product company) sighted by analysts over the years. Several companies market bedside devices that display data from monitoring devices. All of the products on the market today only collect information from their own products. Somanetics’ Vital Sync System is patented and it integrates data from a broad array of hospital bedside devices, such as physiological monitors and ventilators, into a single bedside display for comparison, data management and storage. It has the latest touch screen technology and is extremely user friendly. The system takes the entire patient data collection and management process paperless (something President Obama is pushing very hard for the entire Health Care system). The Vital Sync System is priced at $25,000, which is an acceptable price point for hospitals. The parts are “off the shelf” and the technology is software driven which translates into high margins. Somanetics has placed 8 devices with key customers for feedback.

The potential market for the Vital Sync System relates to the number of hospital beds in this country, not the number of hospital beds designated for adult cardiac surgery. The INVOS monitors are sold or placed initially with a stream of recurring revenue from the sale of the disposable somasensors. The Vital Sync System is sold initially with only a small maintenance contract to provide the latest software enhancements.

The Vital Sync System provides Somanetics a second access point to obtain funds from hospitals. The bedside displays are recognized as a cost saving device and is on every “wish list” for capital. The INVOS System and the Vital Sync System will be marketed separately initially, but clearly combining the two together provides a compelling value proposition for the hospitals.

There have been 4 lawsuits in which a hospital has been accused of negligence because they chose not to monitor a patient who experienced a poor outcome. No other details were known because all 4 lawsuits were settled out of court with confidentiality agreements signed. Lawsuits continue to be the highest potential event that could force hospitals to think of the INVOS System as a cost savings investment.

The company does not view CAS Medical (NASDAQ:CASM) as a serious threat to their business. The company announced they were suing CAS Medical for patent infringement and false and damaging claims. The purpose of the lawsuit seems tactical in several ways. CAS Medical has been claiming that their FORE-SIGHT Absolute Cerebral Oximeter showed measurements to be three times more accurate than those of the INVOS System. The company believes these claims are false and misleading and are based on an unscientific study that will never be published.

The numbers that we hear on the quarterly conference calls refer to monitors that have been placed or sold to hospital accounts under contract. There are numerous monitors installed in many other hospitals that have not been included in the “installed base” because the training period has not been concluded and there has been no sale or somasensor contract signed.

Technical Analysis:

The chart of SMTS looks ok with an upward trendline from the March lows and resistance at around 18.50.  Buying in the mid teens make sense on a risk / reward basis with limited downside due to over $6.00 per share of cash..

Investment Strengths:

Somanetics has experienced double-digit sales growth for the last 12 years, including record revenue in 2009 of $50 million.

Gross profit margins exceeding 85%.

Over $6.00 in cash per share.

Extremely high barriers to entry.

Established and longstanding management team.

Takeover target as a potential catalyst.

To Summarize:

I remain confident in the future of Somanetics Corporation. They are making a lot more headway than the quarterly numbers suggest. The financial crisis has slowed their growth rate in a year that should have shown acceleration. They are doing all of the right things to be successful.

They have or are:

Adding new valuable products to their line.

Constantly upgrading their technology and applications for its use.

Investing at the right time to be prepared for accelerating demand.

Gaining clinical support and evidence critical to the adoption of their technology by the medical community (FDA 510k).

Defending their technology and intellectual property.

Negotiated a three-year extension to their exclusive distribution deal with Covidien for Europe, the Middle East and Africa.

Have set aside 13.5M for potential share buyback.

Disclosure: Long SMTS