Emerging Sleep Solutions Provider On Cusp Of Strong Growth

Rhinomed Ltd (ASX:RNO) is a nasal, respiratory and breathing management technology firm based in Melbourne with a US office in Cincinatti. The company is developing and commercialising its technology platform in the sports, sleep, cold & allergy and drug delivery markets. The technology is based on an adjustable nasal stent system targeted at improving the breathing of the 1 in 4 people that have issues breathing through their nose. Rhinomed currently has two products in the market – Turbine for sports & exercise and Mute for snoring and sleep quality, with the latter being the main driver of the company’s recent success.

The Market

Roughly 40% of men and 30% of women snore. 10% of these snorers suffer from severe sleep apnea but a much larger portion suffer from poor sleep quality or interrupted sleep. In America alone 22m people suffer from sleep apnea and 80% are undiagnosed.

The health risks of poor sleep are numerous and include heart disease, reduced mental acuity, diabetes, stroke, high blood pressure, the list goes on. It is a significant health concern that modern medicine is increasingly paying more attention to.

One of the primary causes of poor sleep is issues with nasal breathing, which forces you to breathe through your mouth and becomes a cause of snoring. One in four people have difficulty breathing through their nose and it is these patients that Rhinomed’s Mute is targeting.

Most investors are well aware of the medically prescribed sleep diagnostics and treatment solutions and the companies that provide them - Resmed (ASX:RMD), Fisher & Paykel Healthcare (ASX:FPH), Somnomed (ASX:SOM) and Compumedics (ASX:CMP). But less attention has been paid to the over-the-counter sleep and snoring aids market, and it is this market that Rhinomed’s Mute is focused on.

The Opportunity

Typically when a patient complains of snoring or poor sleep the first option is an OTC product at the pharmacy, either through their own volition or prompting from a GP or medical professional (or often times their partner). Currently, Breathe Right strips (acquired by GlaxoSmithKline in 2006 for US$566m at 16x EV/EBITDA) are positioned as the clear market leader. These are nasal strips worn across the bridge of the nose while you sleep and are marketed for both sleep quality and decongestion (cold & allergy). These days there are many generic nasal strips as the Breathe Right patents have since expired, yet the name brand continues to lead the market.

Take this test yourself. Walk into a pharmacy and tell the pharmacist you are having issues with snoring or breathing at night. You will almost certainly be directed to Breathe Right as the chemists know this product well. But take a look at the alternatives. You will likely see that the category has little by way of quality alternatives to Breathe Right, other than copy cat nasal strips.

And this presents the opportunity for Rhinomed to position Mute as a premium alternative to Breathe Right strips in the OTC snoring and sleep quality market. Mute is a nasal stent, rather than a strip, meaning it does not leave a residue on the nose or hurt when taking it off (two of the more common complaints with Breathe Right). It comes in three sizes including a trial pack to help users find the right size and is fully adjustable to ensure it fits most noses. A 30 day supply is similarly priced to Breathe Right, cheaper in some pharmacies. Given the category has been bereft of quality alternatives for a long time it seems likely that a good portion of Breathe Right users will give Mute a try.

And while the total market for OTC snoring and sleep aids is large and growing - estimated to be worth US$831m in the US alone by 2021 - it is the ~US$100m of annual revenues generated by Breathe Right that presents the immediately addressable opportunity for Mute as these customers are already paying for a similarly priced product, are accustomed to applying a nasal wearable while they sleep and have had little by way of quality alternatives for quite some time. The market opportunity is much larger than this figure - sales data from Rhinomed has suggested up to 80% of Mute purchasers have never purchased in the category before - but this ~US$100m represents the highly qualified, immediate opportunity.

Importantly Mute has shown it can create avid, loyal customers. Check out some of these reviews. Poor sleep has a negative impact on an individual’s quality of life (and relationship if their partner is kept up by their snoring) so it makes sense that a product that can correct this issue will create happy users.

It has become well recognised by the medical community that when confronted with sleep quality issues that nasal congestion is the first place to start. This is creating opportunity for Mute in the clinical market as GPs, dentists, chiropractors and sleep specialists are seeing the value of Mute both as a screening tool and as a companion therapy alongside traditional treatments like CPAP and MAS (Mandibular Advancement Splints). Encouragingly, a lot of this is happening organically without Rhinomed’s doing (check out this Channel Seven clip as an example) but the clinical market will become an increasingly important channel for the company alongside the retail pharmacy channel.

Expanding Store Footprint

With a well defined market opportunity and a clear strategy to capture it the focus for Rhinomed in FY17 was in establishing a broad global store footprint and retail presence. To this end the company has made tremendous progress over the last 12 months, expanding the store count from 2400 at the start of FY17 to 18,000 today. Mute can now (or shortly will) be found in brand name pharmacies across the US, UK and Australia including Walgreens, CVS, GNC, Duane Reade, Boots, Amcal and Guardian.

In the last 6 months the company has secured some big wins. Both Sigma and Symbion have opened Mute up to their entire networks in Australia with the rollouts into those networks now underway. The Hamacher Resource Group added Mute to its cold & allergy planogram - used by up to 10,000 independent pharmacies in the US - which will be made available to retailers and wholesalers this month.

More recently, and perhaps most significantly, Rhinomed announced that its 12 month trial with Walgreens was successful and that Mute would be rolled out to 4300 stores across the US. Initial orders have been received and stock will be on shelves in August with a promotional program to follow. This deal alone may result in revenue doubling over current run rate levels into 1H18.

In FY18, with the store count having expanded significantly and a footprint established, the focus has shifted to generating sales growth. FY17 saw revenues of $1.7m, up 70% over the previous year. 1H17 eclipsed the entire result for FY16 and in Q3 revenues were slowed as the company transitioned logistics to BOC in Australia and New Zealand, with that revenue having now kicked back in. The FY17 revenue result which saw 150,000 units of Mute shipped to customers was generated from a store count of 2400.

The company recently provided a target of having Mute on the shelves of 13,000 stores by the end of calendar 2017, with another 4000 in the pipeline. That would result in ~10,000 new stores beginning to stock Mute in 1H18 and would create a big ramp up in sales. If the target is achieved then run-rate revenue should reach $5-$6m during FY18 and would result in the company turning cash flow positive, as targeted. Gross margins continue to be well above 70%.

There is plenty of scope for the store count to continue to expand. The company recently began a trial in GNC stores in the US which if successful will lead to a national roll out. GNC have almost 7000 US based stores.

A trial began this time last year with CVS, one of the two largest pharmacy chains in the US alongside Walgreens, and is scheduled to finish in September. A national roll out would be another significant win. As is the case with GNC a national roll out is not guaranteed, but the company’s success in Walgreens would suggest they are well positioned.

Walgreens recently acquired 2000 Rite Aid stores which may eventually stock Mute. And there is potential for Mute to be expanded into further Walgreens stores if sales perform well.

The pipeline of new stores is sufficient to see Mute being stocked in 20,000 stores by this time next year. If this is achieved then assuming per store sales metrics remain at or better than current levels then revenues generated by Mute should be able to hit a run-rate of $10m annually this time next year. Current sell through rates and per store sales metrics may be on the conservative side given the product is only recently being stocked in these stores and promotional activity is yet to ramp up.

Product Pipeline

While in the near term the company is entirely focused on the growth of Mute there is a pipeline of new products at various stages of development that in aggregate address a market opportunity measured in the billions, all based on the same core technology.

Mute Clear utilises the same platform as Mute with a decongestant added and will target the US$8.7b cold & allergy market. Design is being finalised and production scoping is underway. Updates on this product are likely in the medium term.

Another product Rhinomed are developing uses the core Mute technology combined with a blend of calming, anxiety-reducing ingredients. This product will target the US$2b global brain health supplements market, which is growing at 20% pa.

Rhinomed have conducted early stage trials on a technology called INPEAP (Intra Nasal Positive Expiratory Airway Pressure Technology) that targets patients suffering from mild to moderate sleep apnea. It is early days but it has shown promising signs.

Finally, the company is exploring the applications for Mute as a companion therapy for patients with severe sleep apnea. As mentioned earlier the medical community has increasingly acknowledged the importance of ensuring clear nasal breathing as the first port of call in treating poor sleep quality and apnea. Mute is now being used alongside CPAP and MAS as a means to maintaining clear nasal breathing which improves the effectiveness and efficiency of both treatments.

Catalysts

Catalysts in the short and medium term are numerous. Sales are likely to start ramping up in 1H18 as a result of up to 10,000 new stores stocking Mute on their shelves. The Walgreens deal alone should drive a significant increase in sales. The market loves a growth story and if these figures come through as expected it may start to pay more attention.

There is the possibility of further national roll outs from the likes of CVS and GNC, depending on the outcome of those trials. The success in Walgreens bodes well in this regard.

The product pipeline is exciting with Mute Clear and/or an anxiety focused product likely to be the next in line for release. The market does not seem to be paying any attention to the product pipeline but if Mute proves successful it will likely start to price in some success of future products too. These products in aggregate address a market opportunity measured in the billions. Mute Clear alone has an opportunity that is multiples the size of Mute. If the company can grow Mute sales strongly in the next 6-12 months and then release Mute Clear into its existing store presence then the market will take notice.

Strategic relationships appear to be under consideration. These may provide expansions to the store footprint, speed to market for new products and/or validation of Mute’s proposition. They are likely to be significant catalysts.

Australian investors may start to get excited about the product as it appears in pharmacies near them. As the Sigma and Symbion roll out progresses the Australian retail presence will grow and this may see investors recognise the progress the company is making and could be a catalyst for the share price.

The board is highly credentialed, particularly for an ASX listed microcap. Well regarded fund manager Ron Dewhurst is Chairman and a substantial shareholder with 7% of the company. The cornerstone shareholder is US based value investor Whitney George, who owns 18%. Investors of this quality are unlikely to be heavily involved in a small Australian based technology business unless they see a significant opportunity in front of the company. Rhinomed is led by CEO Michael Johnson, who has done a commendable job in taking the business from essentially a start up in 2013 to the emerging OTC snoring and sleep quality solutions provider it is today.

The company expects to reach cash flow breakeven in FY18 and should have sufficient cash (and a $2m untouched facility provided by the Chairman) to manage the initial part of this anticipated growth phase. However, once cash flow break even is achieved it is likely that the best option for the business is to reinvest all free cash back into growing the top line aggressively. The unit economics for RNO are very attractive so the fastest way to generate shareholder value is arguably to scale the business as quickly as possible. Rhinomed has an opportunity to win a respectable share of the OTC snoring and sleep quality solutions market and if it is successful in doing so it will eventually become a target for the likes of GSK, and the market will price it as such.

It has similarities to a Yowie (ASX:YOW) in its early days. YOW established a broad US store footprint, the market started to price in the extent of the opportunity and the company pushed hard for growth, and sales grew rapidly. When YOW had a similarly sized store footprint and pipeline to RNO its market cap was well over $70m, compared to RNO’s cap today at closer to $20m. YOW’s market cap went on to peak at over $180m as sales started to ramp and the product was rolled out to 4300 Walmart stores. RNO’s roll out into Walgreens could potentially represent a similar step change.

If Rhinomed can manage this initial part of its growth phase and show traction to the market then it is likely to be priced on future expectations based on extrapolation of the store count to forward revenues. Doing so implies a substantially higher share price. Helping this will be the fact that in the next 6 or so months the company should be able to provide more solid metrics around per store sales, volume guidance and so on, which is all part of the maturing of the business. If this coincides with a substantially higher valuation than today’s share price with increased investor interest then it may be wise for the board to turn to the market to raise capital and push the growth pedal to the floor. At that point a capital raise - provided it is well managed, at a price significantly higher than today’s and to the right investors - may be a significant net positive, particularly if it coincides with another step change in the growth of the business (e.g another national roll out or strategic partnership) but that is likely some time away.

The market opportunity is clear and the strategy is simple and well refined. The product has shown it can create happy users and is positioned as a premium solution in a market bereft of quality alternatives to the current market leader. The store footprint has been rapidly expanded and it is now up to management to drive sell-in and sell-through. If they do then the next 6-12 months will be a period of rapid growth. In tow are new products targeting large addressable markets while the potential catalysts in both the short and medium term are numerous.

Summary

Rhinomed is not your typical value investment and it does not have a track record of consistent free cash flow generation. Rather it is a case of mispriced growth, and the market loves a growth story. With any growth company you want to get on board at a price that factors in as little potential upside as possible, though that needs to be balanced by the fact that it is very easy to be too early.

It won’t be a straight line trajectory upwards and the company has a lot of hard work still in front of them. But Rhinomed looks like it is a business on the cusp of some impressive growth, of which the share price is yet to starting factoring in.

Capital H is a shareholder in Rhinomed and looks forward to seeing what the company can achieve over the next 12 months.