The conversation at a recent lunch with friends turned to an unusual topic: sleep apnea. Three burly men in their forties breathlessly talked about latest models in continuous airway pressure machines (CPAP) and nasal masks, much like they would discuss their favourite car or gadget.

The wives joked about getting pinged in the face by air escaping from their partner’s mask at night. And how attractive their partners looked with a machine strapped to their face as they went to bed. But everybody agreed their CPAP machine had made a huge health difference.

This anecdote will resonate with sufferers of sleep apnea, their partners, and investors in companies such as ResMed Inc. and the much smaller SomnoMed, which treats the condition through a type of dental mouthguard that aids breathing at night.

Readers of this column know many of its ideas are based on long-term trends. I look for industries that have strong demographic or social tailwinds, and exceptional companies with valuations that have not already captured the upside.

As trends go, the incidence of sleep-disordered breathing problems is a beauty. As the population ages and as the obesity rates rise, more people are being diagnosed with sleep apnea, a potentially life-threatening condition that involves repeated episodes of airway obstruction during sleep due to the relaxation of tongue and airway muscles.

Symptoms include snoring, waking unrefreshed and excessive daytime tiredness. Research shows patients with obstructive sleep apnea have a seven-fold higher risk of death and heart disease. Other findings have shown links between this condition and problems such as mood disorders.

The US National Heart, Lung and Blood Institute estimates more than 12 million people in the US have sleep apnea. More than half of US sufferers are overweight, and potentially millions more are undiagnosed in that country alone.

But being diagnosed and treated for sleep apnea can be a time-consuming, costly process. It usually involves seeing a specialist and overnight stays at sleep clinics to assess breathing before a CPAP machine is prescribed. High rates of non-compliance with CPAP machines is another issue as some find it impossible to sleep with air blowing into their mouth all night, or take their mask off during the night, sometimes without realising it.

However, as diagnosis becomes easier, and as CPAP machines become quieter and full-face, and nasal masks more comfortable, the market for them or dental stgices to treat sleep apnea will grow. Chemists stocking CPAP equipment in Australia is providing new distribution channels.

Market leader ResMed is an exceptional company: its three-year average annualised total shareholder return (including dividends) to July 3, 2014 is 26 per cent. Over five years, the return is 17 per cent and over 10 years, ResMed has delivered an average 12 per cent annual return. However, a one-year return of 4.6 per cent is low by its standards.

ResMed has high gross margins (more than 60 per cent), strong return on equity, low debt, excellent cash flow, high cash reserves and a strong position in the large US market. Surplus cash has helped it buy back shares.

Third-quarter revenue rose 4 per cent to US$397.8 million on the same period last year. The result was generally well received by analysts and led some to upgrade their valuations.

ResMed’s mask sales in the US rose by 4 per cent over the second quarter due to solid uptake of its much anticipated AirFit P10 nasal pillow. It had lost market share in the nasal stgices market, off a high base, and the launch of the Swift FX Nano direct nasal mask last year disappointed. Its Quattro Air full-face mask is still doing well.   

At $5.30, ResMed looks undervalued against broking forecasts. Morningstar has a fair value of $6 a share. Macquarie Equities Research has an outperform recommendation and a 12-month price target of $6.

Consensus estimates have ResMed trading at 18.1 times FY15 earnings, which is reasonable for a high-quality technology company with a strong position in a multi-billion-dollar global market.  Recent price weakness has created an opportunity for long-term value investors, in my view. ResMed has fallen from a 52-week high of $5.94.

I also rate the more speculative SomnoMed. Its oral sleep apnea stgice, which has two dental plates, looks similar to a sports mouthguard. The custom-fitted stgice is adjusted to bring the lower jaw gradually forward and open up airways. It is an interesting option for patients who find sleep apnea machines and masks uncomfortable and intrusive.

Some I know swear by its dental stgices, which apparently take a few weeks to get used to, but have good results for those with sleep-disorder breathing problems.

SomnoMed is on the cusp of much stronger sales growth as it expands in the United States and parts of Europe. Its dental stgices are gaining traction as an alternative to CPAP machines and masks for some patients.

SomnoMed has rallied from a 52-week low of 94 cents to $1.48. Still, I doubt its $66 million valuation adequately captures the value of a company that has a well-received product on the market, a solid foothold in several offshore markets and potential for sharply higher sales growth in coming years.

As a small-cap company that is barely profitable, for now, SomnoMed suits experienced investors who are comfortable with higher risk, and have a longer-term investment outlook.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at July 2 2014.

 

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