Is Somnomed Limited a better buy than ResMed Inc?

This little pocket rocket of a company is up over 50% in the last year alone…

| More on:

It’s no secret that I have a diversified portfolio of small-cap stocks rather than the more traditional (and some would say prudent) pyramid portfolio that mixes stable, established blue-chips, with a few smaller and fast-growing companies.

It’s also no secret that I’m bullish on healthcare stocks like blood plasma company CSL Limited (ASX: CSL) and private hospital operator Ramsay Health Care Limited (ASX: RHC) because the ageing population will drive demand for their products and services. However, I prefer to buy smaller growing companies because of the greater gains on offer. For example, nurse call system provider Azure Healthcare Ltd (ASX: AZV) is up more than 35% since I bought shares less than six months ago.

Another healthcare company I like is Somnomed Limited (ASX: SOM) which I described in June as “quite attractively priced at $1.50 per share.” At that time, ResMed Inc. (CHESS) (ASX: RMD) was priced at $5.50 per share. The latter remains a wonderful business, although it’s not exactly undiscovered. On the other hand, there is relatively little interest in Somnomed partly because the stock is not particularly liquid. However, liquidity may improve since the company has recently signalled its intent to raise more capital.

More importantly, the recent release of Somnomed’s quarterly cashflow statement sent the share price to $1.80, up 20% since June.

That’s because Somnomed now appears to be cash-flow positive, which significantly reduces the risk associated with the company. The company has also reported growing sales in all its markets, and boasted that: “New records were set in all regions during the quarter.” Furthermore, “the good growth… in the second half of 2013/14 in the US is expected to continue, due to the improved dental sales and service operations, excellent acceptance of our Herbst products and results from [the] medical initiative…”

The latest twist in the tale is that Somnomed went into a trading halt on Thursday due to an impending capital raising. The AFR is reporting that the company will raise $7 million from institutional investors at $1.50 and will raise another $1.5 million from existing shareholders. If this is the case, it’s pretty disappointing, as I think the company has sufficient cash already. Selling underpriced shares to institutions for unnecessary cash rarely benefits retail shareholders – if cash is to be raised at all, institutions should not get special treatment. For me, potentially discounted capital-raisings are a black mark against management because it signals that management is happy to favour other shareholders at my expense.

In any event, Somnomed’s revenue will be over $25 million in FY 2014. I think that three times revenue is an attractive price at which to buy Somnomed at this stage in the company’s development, and its pre-audit figure of $25.8 million is 12% higher than my (conservative) estimate of $23 million – I’m always keen to invest in companies that outperform my expectations.

In comparison, I think ResMed is looking fairly expensive. After accounting for (a huge amount of cash) and debt, the market has assigned ResMed an enterprise value (EV) of 2.8 – 3.7 times revenue over the last four years or so. Depending on upcoming results, it does appear that the company is trading on well over 3.3 times revenue for FY 2014. Instinctively, I think a fast-growing company like Somnomed should be priced at a higher multiple of revenue.

Of course, this is just one (basic and flawed) way of valuing Somnomed, because it isn’t really known what margins Somnomed will eventually earn. As operating leverage kicks in and the smaller company starts to generate free cash flow, it will be a lot easier to value it in its own right. Purely because of the unnecessary capital raising, I can’t say for sure if Somnomed is a better buy than ResMed, though I strongly suspect it is.

Wondering where you should invest $1,000 right now?

When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for over ten years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*

Scott just revealed what he believes could be the five best ASX stocks for investors to buy right now. These stocks are trading at near dirt-cheap prices and Scott thinks they could be great buys right now.

*Returns as of January 12th 2022

Motley Fool contributor Claude Walker (@claudedwalker) owns shares in Somnomed. 

More on ⏸️ Investing