Somanetics Corporation: Babysitting your brain
If you are feeling a little lightheaded during brain surgery, you may worry that doctors are taking too much off the top. Instead, there probably isn’t enough blood oxygen coursing through your cranium — a situation Somanetics Corporation (Nasdaq: SMTS) will immediately detect. In times like these, it’s nice to know Somanetics has your brain on its mind.
Somanetics is the guardian angel of the operating room and ICU unit. The company continuously and non-invasively monitors changes in blood oxygen levels in the brain and elsewhere in the body in somatic, or skeletal muscle tissue, using its INVOS system. This is a portable monitor used with single-use disposable sensors called SomaSensors. Of all organs, the brain is the least tolerant to blood deprivation — damage can occur in minutes. Studies show that using the INVOS system to help manage brain blood oxygen can significantly lower cases of major organ dysfunction, improving results and reducing hospital costs.
There are many possible markets for Somanetics’ technology. The Troy, Mich.-based company says the global annual disposable sensor market is worth at least $2.6 billion, with $1.4 billion of that from elderly, non-diabetics major surgeries. It is actively seeking other uses: one current clinical trial is on diabetic patients over the age of 50 who are undergoing major surgeries. Diabetics are at particular risk of oxygen disruptions because of vascular problems. Positive trial results would lead Somanetics to more aggressively market the INVOS System for use in diabetic patients in 2009. The company estimates the diabetic surgery market at $400 million.
Near term, Somanetics’ markets still have huge potential and very low penetration rates. The company first targeted cardiovascular surgeries in 1998; it is a $200 million opportunity with penetration of only 20%. A second focus — pediatric ICU — was first addressed in 2005; it also is a $200 potential market with penetration less than 5%. The third focus — and a current key one — is neonatal ICU. This product is in customer testing and design, and is expected to be addressed in fiscal 2008, although the timing is uncertain. It is seen as a $400 million market.
With the increasing focus by hospitals on avoiding unexpected costs, especially in the operating room, ICU and other critical care areas, Somanetics says there are significant incentives to evaluate and adopt new monitoring technologies. In addition, knowledge is lacking about blood oxygen levels and how deprivation can result in unnecessary medical treatments and costs.
Hospitals are buying into the plan. Somanetics’ revenues are expected to climb to $38.5 million to $39 million in fiscal 2007 through November, more than tripling those in 2004 and up 34% from 2006. Earnings per share are expected at $0.65, according to the average of analysts, up 30% from $0.50 the previous year. Gross margins also have remained solid.
Somanetics, with a market cap of $294 million, had record revenues of $10.2 million for the third quarter ended Aug. 31, up 29%. U.S. net revenues rose 32% to $7.7 million and international sales increased 22% to $2.5 million. Third-quarter net income increased 47% to $0.19 per diluted share, up from $0.13 per diluted share in the same period of 2006.
But Somanetics said when third-quarter results were released in September that it has delayed its neonatal ICU market entry; its guidance for $38.5 million to $39 million in revenues in 2007 reflects lower expectations because of the delay. Customer testing showed changes needed to be made in designs for small babies. For infants, the company plans to begin marketing in early 2008. But for neonates, design changes to fit pre-term infants means the company will file a new 510(k) to obtain clearance from the U.S. Food and Drug Administration; this submission is expected in mid-2008.
The news dashed bullishness. Certain analysts now are content to wait for Somanetics’ future to clear. Matthew Dodds, an analyst at CitiGroup, says the neonatal ICU delay is a result of product redesign to improve the adhesion of the sensor and the 510(k) filing is to expand product labeling. He has a “hold” rating on the stock.
“The delay will hold up sales into the infant market until early FY2008, while the 510(k) filing for the neonatal market is expected to keep the product off the market until sometime in 2009,” wrote Dodds after the release of third-quarter results. He said the delay would be an “overhang” on sales through fiscal 2008.
At Cowen and Co., analyst Sara Michelmore says that the INVOS monitoring system is poised for significant expansion, driven by new end markets and a growing body of clinical data support. A planned increase in direct sales and marketing also should bolster sales. But Michelmore said she sees little room for earnings upside and is neutral on shares.
“Despite good fundamentals, we expect shares to appreciate only modestly near term in light of ongoing execution risk related to new target markets and a notable scale up in sales and marketing,” Michelmore wrote in September. She said she lowered her five-year sales forecast compound annual growth to 32% from 40%.
Somanetics shares reflected the disappointment of the delayed neonatal market entry by selling off to just below $18 per share in the second half of September, only to mount a rally since. They closed Thursday at $22.26, near their 52-week high of $23.63 set in December of last year. With a P/E near 27 based on the average earnings estimate for 2008 at $0.79, shares would seem to be reasonably priced. Somanetics’ 52-week low is $16.08.
The market is expected to become highly competitive. Several companies are researching and developing non-invasive monitors. But Somanetics has a head start, both in the marketplace and with regulators. This should give it an advantage, although there is the risk that others may be more successful than Somanetics in gaining FDA clearance with broader labeling claims, and in manufacturing other products.
Somanetics has huge growth opportunities. But investors need to be just as vigilant with Somanetics as Somanetics (SMTS) is in the operating room. And right now, the company has a couple loose ends to tie up.
