Investing in a Good Night's Sleep

If you suffer from obstructive sleep apnea, or OSA, you're not alone. Millions suffer from the condition and, until now, treatment options have been limited to surgery, or continuous positive airway pressure, or CPAP, devices made by industry leaders ResMed (NYSE: RMD  ) or Philips Respironics, a division of Philips Electronics (NYSE: PHG  )

However, both of those solutions are imperfect. Surgery may or may not fix the condition, and strapping on a CPAP device can feel more like preparation for a jet cockpit than bedtime. As a result, companies like Inspire Medical Systems, formerly a part of Medtronic, are developing new products like Inspire's neurostimulation system, which won FDA approval for use in OSA patients earlier this month.

Time will tell whether Inspire's system will cut into ResMed and Philips Electronics' CPAP sales, but given the potential threat, let's take a closer look.

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First, some background on sleep apnea
More than 20 million Americans are diagnosed with sleep apnea, and the number is climbing every year as undiagnosed patients seek treatment. Globally, industry analysts estimate the total OSA patient population is as high as 100 million people, of which just 20% are currently diagnosed. That has analysts predicting that total spending on sleep-related disorders may swell from less than $8 billion three years ago to more than $19 billion by 2017.

If those forecasts prove correct, it would support demand for ResMed and Philips' CPAP machines, which help prevent a narrowing of the upper airway -- and snoring -- by providing air continuously into the airway. However, patient adherence to using CPAP machines is less than perfect. As many as 50% of patients discontinue their CPAP therapy because of either how noisy the machine is, or how uncomfortable the mask is to wear.

As a result, ResMed, which controls a 40% market share in CPAP machines and 70% market share in masks, and Philips are innovating mask designs to improve comfort... and compliance.

New treatment options
As CPAP demand has grown, payer pushback has increased. The Centers for Medicare and Medicaid Services, or CMS, is a major payer for CPAP machines, and the agency is reducing its reimbursement rates for them. That's got the industry laser-focused on reducing costs and innovating testing and treatment.

ResMed and Philips are not only working on products for at-home testing , but they're also developing autotitrating positive airway pressure, or APAP devices that are quieter than CPAP. These APAP devices could eventually replace the use of CPAP machines given that studies showed patient adherence was 11 minutes longer per night in trials than for CPAP.

However, the biggest changes in treating OSA may not come from APAP, but from solutions being developed by other companies like Inspire.

Image source: Inspiresleep.com.

Instead of delivering air through patient airways, Inspire's OSA therapy uses neurostimulation. The system includes three components: a small generator, a sensing lead, and a stimulation lead. Together, those components deliver small electrical pulses to stimulate airway muscles to stay open based on each patient's breathing pattern.

During Inspire's clinical trial, patients experienced a 68% reduction in apnea events, a 70% reduction in drops of oxygen in the blood, and improvements in daytime functioning.

What's at stake
Despite payer pushback and poor adherence rates, ResMed's sales continue to grow, albeit more slowly than in the past. Sales advanced 4%, to $398 million in the first quarter; however, U.S. sales were flat, at $216 million, as flow generator sales fell 2%, to $93.9 million, due to price cuts, and mask sales advanced 2%, to $122.2 million.

Overseas sales were much stronger, with ResMed posting 8% growth in the rest of the world, led by a 14% increase in European and Asian-Pacific mask sales. ResMed's cost cutting helped lift earnings by 6%, to $90 million in the quarter, as gross margin grew 90 basis points, to 63.3%. That allowed ResMed to buy back 1.6 million shares and declare a quarterly dividend of $0.25 per share.

Over at Philips, the company doesn't break out sales for its respiratory and sleep products; however, those products are accounted for in its home health-care solutions segment, which had sales of about $1.7 billion in 2013.

Fool-worthy final thoughts
The market for sleep apnea devices is big and growing as more patients seek treatment. However, the industry is being squeezed on pricing, and threatened by new competitors.

While we don't know how much of a hit ResMed and Philips sales will take from Inspire's new system, Inspire plans to launch the product during the second half of the year. That suggests investors will want to keep an eye on the results of ResMed and Philips during the coming year to see whether Inspire is winning converts.

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