The respiratory disease market is massive, and it just keeps getting bigger. The good news for investors and patients is that there are plenty of companies working to get relief to sufferers of sleep apnea, COPD, asthma, lung cancer, and more. In this week's episode of Industry Focus: Healthcare, host Shannon Jones chats with fool.com's Brian Feroldi about three respiratory disease medtech companies -- Inogen (NASDAQ:INGN), ResMed (NYSE:RMD), and Inspire Medical (NYSE:INSP). Find out how ResMed could be exploding their market opportunity in a huge way soon, how Inspire Medical is winning over CPAP non-compliant patients, why Inogen's beaten-down stock price should make investors take a second look, and much more.

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This video was recorded on Aug. 7, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. It's Wednesday, August the 7th, and we're talking about respiratory diseases. That's right! More specifically, we've identified three medical device stocks that help treat breathing disorders. I'm your host, Shannon Jones, and I'm joined via Skype by fool.com's medtech and med device guru, Brian Feroldi. Brian, how's it going?

Brian Feroldi: Hey, Shannon! It's quite warm up here in Rhode Island. I'm sweating quite a bit. How about you?

Jones: If it's warm in Rhode Island, that means it's steaming hot here in D.C. I think we're in the 90s today. But I have to tell you, I just came back from California, where I don't think it ever got above the 80s. Coming back here with the humidity, I'm not a huge fan.

Feroldi: California is lovely weather. Good for you that you got to go out there!

Jones: Oh, yeah, yeah. But glad to be back! Really glad to be talking with you again. I love our chats. You're always uncovering those hidden gems in the industry, specifically with the three stocks you've got now, I'm excited to talk about these in the respiratory disease market.

Let's kick things off. For our listeners, just giving them an overview of this particular market. What makes it such an interesting space to invest in, Brian?

Feroldi: Respiratory diseases, believe it or not, are responsible for about one out of every six deaths that occur worldwide. We're talking about a really, really big deal. Some of the major respiratory diseases that our listeners might be familiar with are COPD, asthma, sleep apnea, pneumonia, respiratory failure, lung cancer, etc. These are unfortunately really popular indications for people to get. The other thing is, this is actually a growing market. There's several reasons for that. Most of them are human problems -- obesity, lifestyle changes, smoking, air pollution, global urbanization, aging. All of these are contributing to more and more respiratory diseases every year. 

The market for treatments for respiratory diseases is actually huge. In the U.S. alone, the medical device market that treats respiratory diseases is about $24 billion, and that's growing at about 9% each year. The numbers get even bigger when you zoom out to include the rest of the world. So, respiratory disease, big problem.

Jones: Big problem, and these tend to be chronic diseases. This is not just a one-and-done type of treatment, but these are these ongoing treatments that are required. In this space, this is where we're seeing a lot of innovation in chronic disease management, both from a treatment perspective, even from monitoring in some cases, diagnostic and predictive disease management as well. And when you combine that with all the different drivers that you mentioned, like the aging baby boomer population, the obesity epidemic, and really just an overall increased awareness about these diseases and how to best manage them, you've got all the ingredients for a market that's not only large, but really continues to grow massively. 

With that, let's talk about the first company on your radar and that investors should be paying attention to, Brian. That's a company called Inogen, ticker INGN. Brian, for me, I love a good founder story and I really love founders that start at an early age and are driven to solve a problem, and not just make money. This company currently with the market cap just north of $1.3 billion was actually inspired by a college student's grandmother name Mae. What can you tell us about Inogen and how they got their start?

Feroldi: Really interesting story here. As you mentioned, one of the co-founders had a grandma named Mae. She had a respiratory disease. And her doctor prescribed her oxygen therapy to supplement her breathing disorder. Most listeners have probably seen people that are carrying around a heavy oxygen tank, and they have the tubes going up underneath their nose to provide the oxygen. Well, that's exactly what the grandma was prescribed here. The grandma openly complained to the founder of this business, her granddaughter, that it was not convenient to have this therapy at all. Yes, the treatment was good, but carrying around this huge, heavy device was bulky, it was expensive, it was inconvenient, and it really limited her mobility. So, the granddaughter took it upon herself to figure out a way to make oxygen therapy easier to use, and lower the cost at the same time. 

What they developed was the world's first portable oxygen concentrator. The idea was to actually create concentrated oxygen by simply using the surrounding air. This is a device that's battery powered, and it's carried around, and it's completely wireless. It pulls in the surrounding air and concentrates the oxygen that's in the existing air, then pumps it up to tubes so that the patient can get a higher concentration of oxygen. It's a really innovative treatment option, and it's a very big convenience when compared to having to lug around the heavy oxygen tanks.

Jones: Yeah. Like Mae, the grandmother that inspired the start of Inogen, these patients are limited in their ability to leave their homes. Literally every trip out of the house has to be calculated and precisely planned just to make sure they don't run out of oxygen. So, the more portable, the more convenient, the better. 

I love the technology. I love the founding story. But, at the end of the day, do they actually make money?

Feroldi: Inogen was founded many, many years ago. The idea of portable oxygen concentrators has really caught on. These guys now sell both directly to patients as well as to other companies. They do rentals and they do direct sales. This company has just been a rocket ship. Sales were about $10 million in 2009. That figure rocketed to $410 million for this year. That's their estimate for this year. That's 44% compound annual growth rate. And they're now big enough that they are profitable, they're producing free cash flow, and they have about a 10% operating margin. So, the financials here are actually very, very good.

Jones: And this is a company that checks a lot of the boxes that I like to see as an investor. You mentioned, they are a company that's been exploding in terms of sales. They also have plenty of cash on the books, no debt. You mentioned that they're free cash flow positive. They're profitable. And, they still have founders that are still there, and an experienced CEO at the helm. For me, those are the things I love to see. But for a company like this, it doesn't mean there aren't speed bumps along the way. Sounds like the future is bright, but they have been pivoting their business model recently, too. Is that right?

Feroldi: Yeah, exactly. And when I say that this was a red hot stock, I mean red hot. This company came public at $15 a share in about 2014. Last September, they were trading at $280. Enormous growth. But more recently, their business has experienced, I think it's fair to say, a speed bump. Their growth has really slowed down. Management said that basically, the reimbursement environment is changing. Competition has also picked up. And their sales hires that they have have not had been as effective as their previous sales hires. So, because of that, their growth rate has really slowed down. More recently, they guided down for the full year, and their stock has dropped basically from $280 less than a year ago to about $60 today. It's been a pretty gut-wrenching stock to hold for the last couple of months. 

But a lot of the attributes that we still like about this company are still in place. Like you mentioned before, debt-free balance sheet. They are still growing. They are still profitable. Just not nearly as fast as they were previously.

Jones: I like that they have an expanding product portfolio. It's not just a one-and-done, one hit wonder. They've got, of course, their flagship product, the One G4. It actually recently received reimbursement coverage in France. They've got Inogen At Home. This is for patients who need oxygen therapy during sleep. It's this patient group that's actually estimated to represent more than about 30% of the total oxygen patient base in the U.S. Just in the first quarter of this year, they launched the Inogen One G5 in their direct to consumer channel. That's rolling out domestically in the business to business channel, then to international business to business channel, by the end of the year. 

For me, on the business side, it sounds like they're shifting toward more of a rental revenue model, which basically gives them some reoccurring revenue, even though you're probably going to see some more short-term headwinds as they shift over here. But all in all, I think, because the stock has gotten a little bit beat up, especially with that guidance change that you mentioned in May, this could be a company that, even though it's going to be a bumpy road, could actually be a good buying opportunity now, especially as things start to smooth out, hopefully in 2020, especially on their bottom line.

Feroldi: This is a company that I've actually admired from afar for a long time because their valuation has just been so extreme that it's really hard for me to get excited about owning the stock. But their huge drop that they've experienced over the last nine or 10 months have actually pulled their valuation down to a much more palatable level. This company is trading currently about 30 times forward earnings estimates, which is, I think, completely reasonable given the opportunity and the quality of the business thus far. The estimate for future profitable growth has come down, but analysts are still estimating about 15% profit growth over the next five years. Those are fairly attractive numbers. As you said, it could be a good time to buy the stock, given that its valuation has been so compressed.

Jones: Next up we have ResMed, ticker RMD. Brian, this company is pretty interesting, too. It's a device maker, but it's also a software company, leading the way in digital healthcare management. Even competes with Inogen in some respects. What can you tell us about what ResMed does?

Feroldi: ResMed has been around for several decades now. Their claim to fame is that they were the pioneers, they were the first to develop and launch, a continuous positive airway pressure machine, or CPAP for short. That's a device that I'm sure many of our listeners are familiar with, which is used to treat obstructive sleep apnea. Sleep apnea is when your mouth closes while you are asleep, and you literally stop breathing. A CPAP machine is a mask that you put directly over your mouth, and it creates a continuous positive airway pressure that's forced down your throat, and that keeps your lungs open all night long, so that way, you never interrupt your sleep or anything like that. 

ResMed sells the machines themselves, as well as a whole host of accessories that goes with them -- masks, tubes, cleaning devices. They also recently are getting into the portable oxygen concentrator games, as you mentioned, to compete with Inogen. So, that is the bulk of their business. Those two are about 90% of their sales. 

But over the last year, they've made some investments in the healthcare software market. They've bought out several different cloud-based providers, and they're now getting into the game. They want to create software that helps people to diagnose, manage and treat respiratory diseases like COPD and sleep apnea. They offer these software tools that can actually be downloaded at home that patients can use, that listens constantly to actually detect whether or not people have sleep apnea. And that is a great use of their capital because the sleep apnea market is enormous. I mean, almost a billion people worldwide have sleep apnea. The problem is, about 80% of them don't even know that they have it. So, by creating these tools that help to diagnose sleep apnea, they are, in a sense, building demand for their future products.

Jones: ResMed has this razor and blades model. It's not just the devices, but it's also the tubing and everything that comes with it, which I like about their business model. And thanks now to this software side that they've been investing in and growing, as you mentioned, Brian, now they're also seeing expanded margins moving forward. Holistically, how are we looking at financials right now for ResMed?

Feroldi: As I said, this company's been around for many years. They're much more a mature company than Inogen is. They're growing their top line at a high-single-digit, low-double-digit rate. They're steadily improving their margins by shifting over to more of a software platform. But they have been profitable and free cash flow for many, many years. In fact, they're actually a dividend payer. They've been paying a growing dividend for many years. This is definitely not a high-growth business by any means. But they do have a model in place that allows them to very consistently pump out steady top line growth and then use stock buybacks as well as margin enhancements to grow the bottom line at a slightly faster rate. Given the enormous potential for these guys as sleep apnea becomes more and more diagnosed, they have a really solid, steady-eddy business that can consistently grow at high-single-digit, low-double-digit rates for many, many years to come.

Jones: You talked about how CPAPs work. I think one of the bigger issues, and we probably all know someone who uses a CPAP machine, comes down to compliance. Because you have to wear this big, bulky mask, not exactly the sexiest object when you get in bed. But with that being said, compliance has been a huge issue. It's not just unattractive, but it's bulky and extremely uncomfortable. I've got an aunt that uses one. When you look out at the competitive landscape, there are other competitors -- one of which we'll get to in a second -- that are coming out with technology that's designed to be much less invasive, much less bulkier, and really a seamless experience. How do you see ResMed positioning itself for the future, especially with competition on its heels that are coming up with devices that are just simpler?

Feroldi: There's a couple of answers there. I would say the first is, these guys are the leader in their industry. They are the pioneers. They were the original developers of the CPAP machine. They have decades of experience designing these, and they are constantly rolling out new masks, new tubes, new devices that are smaller, that are quieter, that are more comfortable to wear, that fit a wide variety of face sizes and shapes. They're doing everything they can to make their devices as easy and as comfortable to use. Because, as you mentioned, compliance is a big issue here. In fact, one of the companies that we're going to talk about next is taking advantage of that big compliance issue. But, for the people that choose to use CPAP machines, I do think that ResMed has a defensible position in that they regularly spend heavily on R&D to make sure that their devices are the quietest, the safest, and the easiest to use, as well as the most comfortable. 

Jones: All right. Finally, we've got Inspire Medical as the third stock, ticker INSP. We talked a bit about competition for ResMed. This company is just truly innovative with their implantable device that not only takes away the bulk associated with sleep apnea, but also monitors and controls the breathing for a patient. Brian, what else can you tell us about Inspire Medical?

Feroldi: When a patient with sleep apnea tries a CPAP machine and goes off it for whatever reason, mask discomfort or nasal congestion or any other issues, they historically have had no other options, basically. It's basically CPAP, and that's it. Along comes this company called Inspire Medical, which was actually spun off of Medtronic several years ago. What these guys have done is, they sell an implantable neurostimulator that is inserted directly into the body with a minimally invasive surgical procedure. And their device actually connects directly to the hypoglossal nerve, which controls the movement of the tongue and the other airway muscles. The device actually constantly monitors a patient's airway while they are asleep. And whenever a blockage is detected, it emits a tiny little electrical stimulation to the nerve, which automatically opens up the tongue without the patient having to do anything. So, this is actually a surgically implanted medical device that allows the patient's airway to stay open all night long without having to wear a CPAP machine. Very cool technology.

Jones: Very cool technology. Todd Campbell and I had a chance to talk about this company a few months ago. He said he actually had to use a CPAP machine. He was considering Inspire's technology. On the surface, it would seem that an implantable device, while more convenient and less apt for compliance issues, would be limited to a smaller subset of patients because there's this minimally invasive surgery involved, which many people will tend to put off if they don't have to. So, in some ways, I could see this being a potentially less lucrative opportunity than CPAP machines. But, Brian, when I look at their top lines, and even their margins, I'm just blown away by their performance, especially since they've only been FDA approved in 2014.

Feroldi: Yeah. Between 2016 and 2018, their top line grew at a 75% compound annual growth rate. For this year, they're estimated to grow at least 36% to about $70 million. You mentioned before, one thing that's very impressive is, even at their low relative sales volume, this company is already producing a gross margin on their device above 80%. That is very exciting, when you have both a high gross margin and a high sales growth rate. That can lead to, eventually, magic on the bottom line. 

But the company has not quite crossed into profitability just yet. Last year, they lost about $22 million from operations. But they do have a really good balance sheet. They have $176 million in cash as of the most recent quarter, and only about $25 million in debt. That is plenty of liquidity to continue funding losses as they go forward. But I think the odds are good that these guys could reach profitability relatively soon, given their extremely high growth rate and their gross margin. 

As you mentioned before, one of the questions that I had when I first learned about this company was, how big is their market size? To qualify for this device, you had to have tried a CPAP machine and failed on it. Well, it turns out that about 35% to 65% of patients who try a CPAP machine end up abandoning the therapy. That translates into about 500,000 patients in the U.S. that could qualify for Inspire's device every single year. And from a revenue perspective, that translates into about a $10 billion opportunity in the U.S. alone. The opportunity here is huge. 

Jones: It's huge. They're also looking to expand their approval. They're working right now to lower the age and also expanding internationally. What can you tell us about that, Brian?

Feroldi: They already have approval in Europe and Japan for their device, which is great to see, getting that out of the way. But they're only currently available for sale in Germany because they're not going to go and open up new markets until reimbursement has been established. This is definitely a brand-new category of medical device for treating sleep apnea. When that happens, there's no pathway for them to follow to gain reimbursement. That does take time. But, as those reimbursements come online, they're definitely going to have the opportunity to open up new market opportunities. 

But as I mentioned before, just their opportunity in the U.S. alone is $10 billion versus $71 million in revenue expected for this year. They're not even close to scratching the surface of their opportunity in the U.S., let alone when you add on the international stuff. They can really go slow and take their time with international expansion because their opportunity in the U.S. is just so big.

Jones: Exactly what I like to see, just massive opportunities, both domestically and internationally. Brian, for you, we've talked about three stocks, which of the three would you say is your top pick right now?

Feroldi: I do think that there's reasons to actually like all these companies. They all have their markets that are their niches. As we mentioned at the top of the show, the respiratory market is huge, and this is a growing problem. This is by no means a winner-take-all or one kind of winner. I think this is a market that can support multiple winners. But if I had to choose between these three, my favorite would definitely be Inspire. They are definitely growing the fastest. I like that their margins are already very high. I think they have the most upside potential. I think it's the riskiest of the three since they're not yet producing profits. But for me, the growth investor in me believes that it's the best choice. How about you?

Jones: Yeah, I like Inspire, too, but ResMed I also like. I like the fact that it is a steady-eddy business. Another thing I like about them, especially in the healthcare space, is that we're becoming so much more connected in terms of the digital health age. So, when I see their software business and the investments that they've been making on the software side, it's not just about the device, but it's about the analytics, the AI, and the trend toward more comprehensive monitoring and diagnostic tools. The more that we can close that loop of not just treating, but being able to predict and monitor and really take out the element of patient-initiated treatment, which of course leads to compliance issues, and even being able to loop the physician in remotely, I get really excited about that. I could see their software being applied to multiple therapeutic indications even beyond this. I like Inspire for all the reasons that you just mentioned, but I also like ResMed. I like that razor and blade business model, and I like where they're going with software.

Feroldi: Yeah, I think they're both great companies. Even Inogen -- it's kind of a turnaround play right now, but I definitely think there's room for all three of these stocks in an investor's portfolio.

Jones: Totally agree. Brian, thank you so much for joining! Hopefully we'll have you back on the show very soon because we want to continue to pick your brain, as always. 

For our listeners out there, we want to thank you so much for tuning in! That'll do it for this episode of Industry Focus! As always, people on the program may have interest in the companies discussed on the show, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. This show is being mixed by Austin Morgan. For Brian Feroldi, I'm Shannon Jones. Thanks for listening and Fool on!