Best Stock for 2009: Somanetics

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Good riddance to 2008, and welcome to 2009. We, the investing populace, scarred by the past year's bludgeoning, are desperate for places to park our money. But where? Retailers aside from Wal-Mart (NYSE: WMT  ) are sucking wind. Restaurants not named McDonald's (NYSE: MCD  ) are having trouble drawing flies. Financials? Energy? Industrials? Eep!

Face it, when short-term Treasury yields are negative and investors are willingly giving Uncle Sam their money for 30 years at 3%, the appetite for risk is nearly nonexistent. And so, in this environment of palpable fear, my best stock for 2009 comes out of suburban Detroit.

No, it's not a car maker
My 2009 star is Somanetics (Nasdaq: SMTS  ) , a company I've twice recommended in the pages of our small-cap value newsletter, Motley Fool Hidden Gems Pay Dirt. Somanetics makes a system, consisting of a monitor and disposable sensors, to continuously monitor cerebral oximetry -- that is, brain oxygen saturation. Favorable clinical research is piling up in Somanetics' favor. Continuous monitoring of cerebral oximetry in adult cardiovascular surgery has been tied to a reduced frequency of unfortunate outcomes like major organ dysfunction or stroke.

The disposable nature of the sensors imparts a razor/razorblade nuance to the story -- additional monitors provide greater opportunity for sensor sales. However, monitors aren't placed carelessly to spur sales growth at any price. Only after the receiving hospital staff is properly trained by Somanetics' personnel are sensor sales allowed to ramp.

But Somanetics isn't content simply to rest in an area where it's arguably the first mover. It is branching into new markets, such as the pediatric intensive care unit (PICU) and neonatal intensive care unit (NICU), and working on new applications of the technology.

Who wants catalysts?
Cerebral oximetry data has been collected in the Society of Thoracic Surgeons database since January 2008. This database -- geared toward quality improvement and the establishment of best surgical practices -- should have collected sufficient data by early next year to allow researchers to better assess the impact of monitoring and managing this metric. If the data is consistent with past studies, Somanetics could have a powerful impetus for greater interest from non-monitoring hospitals.

In the NICU and PICU, Somanetics has launched a new sensor specifically engineered for these tiny patients. The sensors are smaller and employ a very mild adhesive to minimize damage to the sensitive skin of premature babies. To the investors' advantage, these smaller sensors sell at a higher price point, and current PICU customers who had been employing adult sensors on their patients are expected to migrate to them.

These infant sensors also offer Somanetics an opportunity to broaden the applications for their sensors. They're now also able to apply sensors over the abdominal region to monitor the kidney and bowel in infants -- in whom such organs are nearer the surface (they tend to get ... umm ... "deeper" as we age, beyond the sensors' reach). The PICU and NICU markets represent an incremental $600 million market.

Some final bonuses: Covidien (NYSE: COV  ) distributes Somanetics' products in Europe under a deal due to expire in just over a year. The current deal is priced favorably for Covidien, but I expect Somanetics to recapture some of that discrepancy under a renewed deal. And Somanetics' products also tend to be somewhat recession-resistant. It's hard to envision a conversation such as this: "Sorry, Mr. and Mrs. Smith. We can't monitor your premature baby's brain oxygen level because of the economy."

What's it worth?
Somanetics' first-quarter earnings disappointed, and the stock plunged more than 50% in weeks. But the poor results were driven by low hardware sales (which tend to be "lumpy," and which have since rebounded to new record highs) and a slower sales ramp of the new infant sensors (which have since launched and exceeded sales goals).

Broadening our perspective beyond a single quarter, Somanetics today presents us with a rapidly growing, capital-light, debt-free business that generates a lot of cash. Margins are strong and its cash hoard makes up a fifth of its market value. It’s trading near $17, but my discounted cash flow model -- which incorporates slower-than recent growth, baseline free cash flow of $11 million, and a 12% discount rate -- suggests it's worth closer to $24 today.

As to the company's ultimate fate, I suspect in the next decade we'll see it acquired at a premium by a larger purveyor of medical devices such as Johnson & Johnson (NYSE: JNJ  ) , Abbott Laboratories (NYSE: ABT  ) , or Becton, Dickinson & Co. (NYSE: BDX  ) .

The Foolish bottom line
Somanetics offers what I believe to be a great investing opportunity -- one tinged with some tremendous growth potential, yet priced as if that growth won't happen. If you agree that Somanetics will beat the market from here, or if you think that it's sure to disappoint, tell us what you think in Motley Fool CAPS.

Covidien and Wal-Mart are Inside Value selections. Johnson & Johnson is a choice of Income Investor. And Somanetics, as noted, is a selection of Motley Fool Hidden Gems Pay Dirt. Try any of these newsletters free for 30 days.

Fool analyst Jim Gillies owns shares of Somanetics, but not of any of the other companies mentioned. The Fool's disclosure policy always gives itself enough oxygen.


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  • Report this Comment On December 31, 2008, at 1:04 PM, woo131 wrote:

    It would be a good idea to realize that they have competition with their cerebral oximeter, and other companies have slightly superior technology [CASM]. I don't think the present management is capable of capitalizing on their lead. Furthermore, they are a one trick pony, so if they don't compete well they are lost.

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