Description

  Somanetics (SMTS) --$11

• High-growth medical device company with sales that should be reslient vis-a-vis declines/freezes in hospital capital spending due to (i) price point and end-markets, (ii) high share of revenues from recurring revenue, existing "no-capital" business model with attractive returns and growth catalyst independent of spending/reimbursement environment
• Stock inappropriately weighed down by comparison to larger-ticket med-tech peers and overly-conservative 2009 guidance
• Substantial imbeded 2010 revenue and margin improvement through renegotiation of legacy distribution agreement
• Substantial downside protection in the form of net cash position and recurring revenue under "razar-and-blade" sales model

Company & Product Overview

Somanetics Corp.(SMTS) is a single-device medical products company that markets the INVOS^TM cerebral and somatic oximeter, a portable device that measures blood oxygen content in the brain and other body tissues to detect supply-demand imbalances in localized oxygenation, most commonly hypoxia (inadequate blood-oxygen content) or ischemia (inadequate blood flow).  The device does this via a set of disposable sensors (2 or 4) that produce and receive refracted near-infrared light to measure the hemoglobin and oxygen content of blood.  The Company was founded in 1993 but remained development stage until its current CEO, Bruce Barrett, joined the SMTS and focused development. The Company received FDA approval for its first generation device in September 2000 and focused marketing on the cardiac surgery market until Q1 2005, when it began marketing to device to pediatric intensive care units (PICUs).  In Q2 2006, SMTS received approval for and began marketing a 4-sensor device that was more appropriate to ICU use.  In Q1 2008, the Company launched a smaller, pediatric/infant sensor (appropriate to patients under 40kg) and, in May 2008, obtained FDA approval for expanded labeling for use of the device anywhere in the body (previously labeling limited use to cerebral and somatic tissue despite substantial off-label use in PICUs).  Following these developments, the Company began marketing the device for use in the neonatal ICUs (NICUs).

SMTS markets the INVOS system under a "razor-and-blade" model - selling the INVOS system at a list price of $25K/unit ($21K after discounts) and single-use sensors at a current ASP of $100 ($175 for infant sensors).  In 2008, 72% of global revenues were derived from sale of a total of 425K sensors used on an installed base of approximately 4300 devices (versus 28% derived from the sale of 974 systems).  In the U.S., SMTS sells this product via a 55-personal sales force covering the cardiac surgery departments, anesthesiologists and PICU/NICU physicians.  Internationally, the INVOS system is distributed by Covidien (except in Japan where it is distributed by Edwards Life Sciences) under a 2000 agreement that expires next February.  In the U.S., the Company offers INVOS Systems to cardiac surgery departments under a "no-cap" program in which the device placed for free in exchange for sensor purchase commitments (historically, this has accounted for 45-50% of total device placements)[1].  In 2008, SMTS's blended gross margin was 87%, comprised of US device and sensor margins of 85% and 90%[2], respectively and lower international margins of 78% and 85%, respectively. International margins are lower despite comparable international ASPs because of deeply discounted wholesale pricing under the Covidien contract.

 Product Markets & Competition

In its traditional cardiac surgery market, SMTS markets INVOS to monitor oxygen availability to the brain during bypass and other procedures at a high risk for hypoxia or stroke.  A rough estimate of the addressable size (global) of this market is approximately $200mm in annual sensor sales.  A substantial majority of SMTS's sales to date have been in this market (inclusive of pediatric and neonatal surgeries) and the Company has market penetration of slightly less than 20% (with competitor share appearing negligible).  In addition, management believes that the surgical market could eventually be expanded to a broader set of high-risk surgeries (those on elderly patients posing a high-risk of hypoxia; roughly $1bn) but this is speculative and would be much more difficult to penetrate with a small sales force.  Despite the absence of distinct payor reimbursement for INVOS monitoring, adoption in the cardiac surgery market has been spurred by two well-publicized clinical trials and over 600 presentations, study abstracts and published papers (many available on the Company's website) demonstrating its efficacy in avoiding surgical complications and reducing associated cost drivers (e.g., ventilation time, ICU time, hospital stay).  In January 2008, INVOS monitoring was included by the Society of Thoracic Surgery (STS) database program - the most extensive national database for the collection and analysis of cardiothoracic surgery practices and the most common venue by which standards of practice are evaluated and adopted.  SMTS expects that the first set of results on INVOS efficacy using this database will begin dissemination in mid-2009 (based on 1-year results).

Conversely, the Company has more recently been targeting PICU and NICU markets in which the device is used for diagnosis and monitoring of various blood-oxygen conditions (e.g., bowel and kidney ischemia in premature infants).  While the Company has nominally targeted these markets since early 2005 and 2008, respectively, these efforts, until recently, lacked a dedicated sales force and were stymied by device design (e.g., 2 sensors) and narrow FDA labeling.  Nevertheless, INVOS monitoring has been used extensively in post-operative pediatric and neonatal patients (accounted for over 20% of sensor sales in 2008) and has been used off-label by PICU/NICU physicians since introduction of the 4-sensor model.  In 2008, SMTS added 15 sales and education staff to target this market and the Company will further grow this staff in 2009.  While somewhat untested, demand in these markets (particularly neonatal) appears anecdotally very strong, driven by limited alternatives to diagnose and monitor common conditions.  In discussions with two neonatalogists (neither currently using INVOS), both confirmed extensive off-label use at other institutions, were aware of the device and described it as a high priority item for their departments.  Collectively, the size of these addressable markets (globally) is approximately $500mm in annual sensor sales (management estimates fully-saturated sensor sales for these markets at $200mm and $400mm respectively, but based on a rough sizing excercise, the former is probably overstated by a factor of 2x).  Together with the cardiac surgery market, the stabilized device installed base required to serve these markets at full penetration would be approximately 49k devices (versus current installed base of 4,300). Substitute methods of analyzing localized blood-oxygen concentrations across these various applications, while available (e.g., invasive jugular bulb catheter, trans-cranial Doppler, EEG, intracranial pressure monitoring, blood analysis), all suffer from obvious deficiencies (e.g., surgical invasiveness, cost, static measurement).[3] 

Direct competition is a more nebulous issue.  While, SMTS holds 11 U.S. and 2 international patents on various aspects of INVOS, management readily acknowledges that they provide limited protection and, in fact, there are at least two competing optical spectroscopy devices on the market for cerebral monitoring - Fore-Sight, a device marketed by CAS Medical Systems (marketed in the U.S), and a line of loosely-branded devices made by Hamamatsu Photonics (marketed only in Japan but reportedly conducting a clinical trial for FDA approval).  However, both companies appear to have made limited inroads with these products. While CAS Medical received FDA approval for its device in December 2006, Fore-Sight sales were only $2.3mm in 2008 with an installed base of 151 monitors (1/30 that of INVOS) and continues to rely on distributors for domestic sales. Moreover, while there was substantial concern going into 2008 that CASM's practice of giving away its monitoring device would force down U.S. purchases of INVOS systems, the ratio of U.S. placements loaned under the no-cap program has actually declined.  Hamamatsu's products, conversely, appear to be used in Japan primarily in research settings and have negligible clinical market share.  Moreover, while SMTS management believes several medical device/life sciences companies may have competing products in development (most notably, Hutchinson Technology), they note that they have heard such "industry chatter" for several years with limited actual market entry and also voice the view that low market penetration should permit multiple systems to thrive.  Finally, while CASM recently received FDA clearance to market its product in neonatal units, both Fore-sight's sensing technology and 2-sensor configuration make it less applicable for non-OR use.  That said, particularly in light of potential pressure on device pricing in the current hospital capital spending market, the threat of competitive entry clearly remains a chief  issue of concern.

Why the Stock is Down

At $11.21, SMTS's share price is at its lowest level since mid- 2004 - a year the Company ended with $13mm in sales and global installed base of 900 devices.  The stock is materially below the prior 52-week low of $12.46 established last March when the Company surprised with an extremely disappointing Q1 2008, including a year-over-year decline in U.S. device sales and weak international sales growth (SMTS last traded below this level in mid-2004). Subsequent quarters established fairly clearly that this Q1 miss was an anomaly caused by lumpy device sales given SMTS's size into what is seasonally the weakest quarter for medical device spending and a de-stocking program at Covidien that completed in the quarter.  Subsequently, SMTS briefly topped $25 before generalized concerns over hospital capital spending began to weigh down the med-tech sector last summer following weak guidance by GE and other large device companies.

However, the current share price trough is predominantly a function of very weak 2009 guidance provided by SMTS's management in conjunction with its Q4 earnings release.  While Q4 performance was exceptionally strong[4],  SMTS management did four things that severely irritated/worried the Street: (i) they guided to below consensus 2009 revenue growth and gross margins, (ii) they announced the acquisition of a development-stage medical device company in the midst of a historical capital spending squeeze (ICU Data Systems for $2mm; dilutive in 2009), (iii) they added $8mm of projected 2009 opex to ramp-up selling into the PICU/NICU markets and develop the acquired product, and (iv) they did not announce an extension of the Covidien contract and began preparatory efforts to build a direct international sales force if no agreement is reached.  Collectively, SMTS guided to 2009 revenue growth of 15% (versus 23% in 2008), operating margins of 20% (versus 29% in 2008), implying EPS of $0.60 (versus $0.76 in 2008).  While management was clear that they had witnessed no deceleration in sales subsequent to the end of the quarter and guidance estimates reflected general conservatism, Street estimates quickly revised to meet them.

Investment Thesis

1. Several aspects of SMTS's business model should make it resilient in the face of dwindling hospital capital budgets / frozen credit markets

First, while SMTS's share price has been punished to a degree comparable to med-tech companies with narrow product lines solely devoted large-ticket ($1.5-$4.5mm) products (e.g., ISRG, VAR, EKTA.AB, ARAY), the INVOS system sells for approx $21k.  Unlike the radiation oncology systems and surgical robots marketed by these latter companies, INVOS purchases do not require external financing and, in general (for individual device purchases), are not large enough to require line-item approval in corporate-level budgeting (i.e., purchase decisions are made departmentally out of regular funding).  While these budgets are likely to be smaller than in prior years, purchase resistance should be graduated, not absolute, even in the face of a "spending freeze".  More broadly, INVOS purchases are less conspicuous to corporate administrators.  While lack of specific payor reimbursement could prove an issue, the system's value to hospitals in cost avoidance should be modestly enhanced in the face of reimbursement cuts.

 Second, the heavy weighting of SMTS' recurring revenues from sensor sales (72% in 2008) should help insulate the Company's top line amid sluggish device sales.  SMTS obtains a greater share of revenues from recurring sources than any other medical device company I am aware of (e.g., 45% for ISRG, 10-20% for radiation oncology system providers).  Moreover, with the Company poised to grow PICU/NICU placements (utilizing 4 rather than 2 sensors) at a faster rate than surgical placements, average sensor utilization (per device) should improve even if device sales flatten or decline.  Finally, the Company should continue to benefit from the higher ASP of its infant sensors as they increase in sensor mix (generated a 6% growth in blended ASP in 2008).

 Third, the Company already has established a no-cost program for device placement and can profitably expand it if necessary. On a unit-cash basis, the INVOS system costs approximately $3,250 to manufacture[5] while the gross margin per adult sensor sold in the U.S. is approximately $95, yielding break-even sales for a no-cap placement of approximately 34 sensors.  With average device utilization (sensors/device) of approximately 32 sensors per quarter (in 2008), a no-cap placement becomes profitable after less than 4 months of steady use.

 Fourth, adoption of cerebral oximetry as a "standard of care" following results from the STS database (for all cardiac surgeries or a subset) would be a growth driver largely immune from hospital budget pressures.  Once accepted as such a standard within the surgical community, monitoring is effectively mandated by malpractice law and state licensing requirements. 

 Finally, SMTS' target markets (cardiac surgery, PICU and NICU) are three of the traditionally best-funded departments within tier-1 and tier-2 hospitals (particularly non-profits) due to the primacy of cardiac surgery in driving institutional reputation and high-profit patient volume and the outsized philanthropic support typically provided to PICU and NICU departments. Particularly given that INVOS is generally a department-level purchase, its target departments enjoy relatively deep pockets.

 2. In the short-term,  SMTS guidance for 2009 (generally adopted in Street estimates) is exceedingly conservative and will probably be beaten

Management top-line 2009 guidance assumes flat device sales and 17% growth in global sensor sales (weighted heavily toward the U.S. with 21% sales growth versus 6% internationally).  While device sales could flatten (or even weaken) in the current climate, $4mm in additional G&A forecasted by management in 2009 is due to a 31% increase in its U.S. sales force (17 new salespeople and medical educators targeting the PICU/NICU markets).  While rep productivity will require time to ramp up and can't necessarily compensate for a weak sales environment, the sheer increase in institutional coverage (particularly in H2 2009) should drive incremental sales.[6]  Internationally, while there is a palpable risk of channel disruption in 2009 if the Covidien contract is not renewed, this is probably mitigated by annual purchase commitments the distributor has made to SMTS[7] and (according to management) Covidien's good-faith marketing efforts scheduled for the first half of the year (e.g., $450K spent on a French PICU/NICU conference). Moreover, management continues to voice high confidence in its ability to reach an agreement with Covidien during H1 2009. In the totality, flat device sales guidance appears pessimistic. 

By contrast, 17% sensor sales growth appears downright unrealistic given (i) the global device installed base grew by 45% in 2008 (weighted to the back half of the year), (ii) even flat device sales in 2009 would add an additional 26% to the global installed base (1,138 units to 4,326 at year end) and (iii) 6% sensor ASP growth in 2008. Even if one simply applies a half-year convention to installs and assumes no ASP growth in 2009, sensor sales should increase approximately 38-39% absent a drop in sensor utilization (per device).  While management's logic underlying the forecasted 6% growth in international sensor sales (weighing down the average) is to hedge the risk of distributor apathy if the Covidien contract is not renewed, this would appear to require a situation in which Covidien failed to execute on a substantial number of inbound orders (e.g., a 20-25% reduction in utilization among the current installed base). Not only is that unlikely, but it would likely be actionable.

Moreover, the 200bps decline in blended gross margin (note that this is implied by the guided operating margin) is completely at odds with guidance that both (i) sensor sales growth will outpace device sales growth and (ii) domestic sensor sales growth will outpace international growth.  Both mix shifts would, other things being equal, improve blended gross margin and management explicitly stated on the Q4 call that guidance did not include an erosion in either wholesale or retail ASPs. Consequently, 2009 gross margin should, at least, remain stable (at 87%).

Retaining the conservative guidance of flat device utilization but forecasting 30% sensor sales growth (allowing for a moderate decline in utilization) with stable gross margins at 87% (blended), 2009 performance should be substantially better than guidance - 23% revenue growth, 26% operating margins and EPS of $0.79.

3.  Renegotiation of the Covidien Agreement Represents Tremendous 2010 (and beyond) Upside with Little Downside Regardless of Execution

Much of SMTS's Q4 call focused on execution risk around the prospect of going direct in international sales if the distribution agreement is not renewed. 2009 G&A guidance included $2mm for additional sales management in Western Europe to "either" support Covidien or manage recruitment efforts if no agreement is reached.  It did not include an additional $3-4mm ($7-8mm run-rate; mgmt estimate) that will be needed if the Company ultimately builds an international sales force (presumably headcount of 30-35). Subsequent sell-side commentary has focused on potential disruption of the international business in such a contingency.  However, the economics of the current Covidien contract -- entered into when SMTS was a new commercial entity -- are so onerous that escaping them more than compensates for any operational disruption. Under the contract, SMTS provides equipment and sensors at wholesale prices of approximately $9100/unit (versus $21,000 retail) and $25/sensor (versus $106 retail). Thus, while Covidien sales from this relationship constituted 14% of SMTS revenues in 2008, they accounted for nearly 35% of global unit sales. Factoring in the foregoing, the impact of going direct in Covidien territories could be as high as an incremental $14mm in (2008 pro forma; +34%) gross margin - making it, hands-down, the largest near-term catalyst for revenue and profit growth.

 Even in the short-term, this impact is so large that it should compensate for any channel disruption from the transition.  This is because the incremental margin on sensors in 2009 ($11.1mm) is more than both the estimated incremental G&A expense ($7-8mm) and the margin on 2008 Covidien device revenues ($2.6mm).  Consequently, even if the migration to a direct sales force is so disastrous that SMTS sells no devices in former Covidien markets in its first year of operations, the increased margin on sensor sales should compensate for the loss in device sales and the incremental G&A of the sales force.

In the more likely scenario that SMTS and Covidien are able to reach an agreement, SMTS will enjoy higher wholesale prices without the execution risk.  For modeling purposes, I assume they split the difference on wholesale rates -- $15K/unit and $65/unit respectively (retaining very healthy wholesale margins for Covidien).

4.  In the medium-term, SMTS appears to have strong growth catalysts in both its traditional and new markets

While penetration of the cardiac surgery market appears to have slowed in late 2008 (YOY device sales were up only 3% in Q4), this could prove an anomaly given very strong Q4 2007 sales and the exceptionally high budgetary uncertainty for hospitals in the quarter.  Moreover, the prospect that INVOS monitoring could evolve into a standard of care based on STS data (against current market penetration of 20%) is high if results are consistent with prior data and, as noted above, this catalyst is largely immune from hospital fiscal issues.   Even if INVOS monitoring is ultimately only adopted in the most-acute 50% of cardiac surgeries, this would amount to 150% growth in utilization and could require a doubling of the installed base (based either on device utilization limits or institutional coverage given INVOS is in less than 50% of U.S. cardiac surgery centers).  While device sales are unlikely to exceed (at least in the U.S.) the 35%+ growth rates obtained in 2002-2007 given the current installed based, a re-acceleration in device sales (particularly as hospital budgets loosen) to 15-20% p.a. appears reasonable in 2010 and beyond (probably conservative if adopted as a standard). Outside the U.S., where the installed base is considerably lower but the sales coverage is more difficult, comparable outer-year growth rates should be achievable.

Successful penetration of the PICU and NICU markets could be even more robust than SMTS's previous entry into the cardiac surgery market given (i) these markets are collectively 150% larger than the cardiac market, (ii) institutional concentration is higher (i.e., roughly comparable number of hospitals) and (iii) pediatric and neonatal critical care physicians generally require less clinical evidence to adopt new technology that surgeons.  Consequently, successful penetration of these markets (to 20%) over a period of 5-6 years (versus 8 for cardiac) appears reasonable (and probably conservative given the greater sales force commitment SMTS is putting behind this effort.  With such penetration representing an additional installed base of approximately 6,250 units (roughly 150% of the current base) and annual sensor sales of 800K (200% of current annual sales), the incremental contribution to total device sales growth from such penetration could easily exceed 30%p.a.(if successful).[8]  

 Consequently, outer-year device sales in an Upside Case in which both additional penetration of the cardiac market and successful entry into the PICU/NICU markets occurs could conceivably exceed 45%.  Taking an (arbitrary) 50% haircut to this view for more modest execution, I model 20-25% device placement growth as a Base Case in outer years (see Appendix B for financial projections and assumptions).

5.  Downside protection in a more hostile capital spending or competitive environment (Downside Case) is substantial

Amid greater competition (i.e., price erosion) and/or a more dire and prolonged hospital spending environment that previously described (e.g., multi-year cuts to department-level budgets), SMTS's business model should be able to adapt.  Specifically, the Company could move to strictly no-cap placement model in the U.S. and continue to benefit (via sensor sales) from expansion of its installed base.  While competitors could undertake similar actions, low current market penetration should permit multiple entrants without compromising additional penetration. Even amid substantial declines in international device placement (e.g., down 50%) and pricing (e.g., U.S. sensor ASP to $60), SMTS should be able to sustain modest profitability under its current cost structure.  Moreover, growth in the Company's cost structure since 2006 has been discrete (ie., additional sales headcount, stock comp, outsourced R&D) and should be amenable to restructuring.  Provided the Company can restructure back to its 2006 opex, SMTS should be able to stabilize EPS and UFCF per share at approximately $0.53 and $0.83 by 2011 while remaining cash flow positive (YE 2010 cash of $101mm or $7.70/sh).

6.   Sell-side analysis of SMTS generally ignores several miscellaneous factors that materially improve valuation

Street analysts - SMTS is covered by Citi (hold), SunTrust (reduce) and Maxim Group (buy) - uniformly overlook the following sources of value when they value the Company (based on EV/EBITDA and P/E multiples):

• Long-term investment in treasuries:  While cognizant of SMTS's substantial net cash balance, all three analysts ignore $12.8mm ($0.98/sh) in "Long-term Investments".  This balance is comprised of U.S. treasury and agency securities due 2010 and 2012.  Given current market yields, these securities should probably be valued at a premium.  However, I value them at book value.

• Net Operating Loss Carryforwards: SMTS's cash tax rate was 2% in 2008 as it works off accrued NOLs.  As of FY2008E, the Company had $20.5mm in remaining carryforwards that should be used over the next 2-3 years. However, multiple valuations of SMTS fail to adjust for this (implicitly or explicitly).

Valuation

Utilizing a discounted cash flow methodology methodology (2011 terminal year) with the following assumptions to value the Company under a Base Case (70% probability), Upside Case (10%) and Downside Case (20%) forecasts, I reach a target price of $23.

Forward multiples based on this target price (relative to Base Case) represent a substantial discount to consensus forward multiples for small/mid-ticket medical device companies and a discount to multiples of large-ticket hospital equipment companies (save for 2009).

 Additional Considerations

• ICU Data acquisition - Forecasts implicitly assume that acquisition and subsequent development funding yield no incremental sales (+)
• Development agreement with Shirley Research Corporation - R&D includes contractual payments to fund alternative NIRS product development but no resulting revenues are projected (+)
• Share buyback -- $13mm remaining under current authorization and currently very accretive (+)
• Lack of concentrated institutional ownership (+)
• PICU/NICU placements to date appear to be primarily driven by post-operative care of cardiac surgery patients; while anecdotally very strong,, demand for other NICU/PICU applications has not yet been demonstrated in sales (-)
• Volatile quarterly performance based on shipments (-)
• Limited intellectual property barriers to entry and limited visibility into potential competitive entry (-)
• Historically, the Company has not realized strong operating leverage given G&A and R&D investments (+/-)
• Gradual trend of declining device utilization (sensor sales/installed base) - e.g., 34/qtr in 2007 versus 32/qtr in 2008. This trend appears to be a function of initial stocking which should abate as the installed base grows (currently modeled based on core device utilization of 28sensors/qtr based on 2008 results and one quarter of initial stocking) (-)

[1] No-cap placements are capitalized as PP&E and depreciated into COGS over 5 years.

[2] Per discussion with SMTS IR.

[3] As one example, in NICUs, the only viable alternative method for diagnosing and monitoring hypoxia due to poor lung formation (a very common complication), appears to be blood analysis (i.e., CO2 concentration).  However, given the limited blood volume of premature infants, recurring blood drawing is, itself, problematic.

[4] Total revenues were up 21% (YOY) and EPS of $0.25 (versus $0.19 in Q407) mildly beating consensus by 3 cents.  This stood in sharp contrast by misses announced by other hospital equipment companies (e.g., ISRG, HOLX, VAR).

[5] Based on $533K capitalized into PP&E under the no-cap program in 2008 and 164 estimated no-cap placements.

[6] (i.e.., current sales coverage must be low relative to approximately 1600 NICUs and 500 PICUs in the U.S.).

[7] While the absolute amount of the 2009 purchase commitment is unknown, management did note on the Q4 call that Covidien did not meet its 2008 commitment and would accept a true-up delivery in Q1.

[8] Average annual sales into PICU/NICU markets over the 6-year period of 1,050 achieved by year 3.

Catalyst

1. Adoption as standard of care in cardiac surgeries (or subset)
2. Renegotiation of Covidien contract
3. Beating on 2009 guidance.