A global business that's all about sleep

Rob Douglas is the Chief Operating Officer of ResMed which has been a fantastic stock for investors, particularly over the last six years when it’s delivered a 30% compound growth rate in the share price since this time in 2016, but really, over the longer term it’s been a wonderful stock. It began in 1981 as an Australian invention for dealing with sleep apnoea at the University of Sydney by Professor Colin Sullivan and eventually it was picked up by a guy called Peter Farrell, and his son, Mick Farrell, now runs the business. 

Over time, it’s become a global business, now based in San Diego and it’s one of Australia’s leading international champions along with CSL. They’ve now got a market cap of $20 billion dollars. The thing about it for investors is how do you get your head around a 40 times PE. The current share price is 40 times the earnings per share that was just announced for the year to June 2018. Even if you look ahead at the growth rates, according to analysts, the PE is still 35 times what earnings per share will be in a couple of years’ time. It’s a tremendously expensive stock but that hasn’t been a problem over the last six years or so because it’s delivered that sort of growth every year, year on year. And so, you don’t mind paying 30-40 times PE for a stock that’s growing at 30% a year, which is what’s been going on.

The question then, which Rob Douglas answers, or at least I put to him, is where’s the growth going to come from from here? That’s really the sort of focus of the interview, where’s the growth coming from? The answer, he says, is from growth in market share and diagnosis in treatment of untreated apnoea patients around the world which is a large number of them. There’s close to a billion people have got sleep apnoea and very few of them are being treated. It’s basically a story not so much about market share, although they are increasing their market share despite growing competition. But it’s about market penetration. But look, it’s a fantastic company, really worth listening to.

Here's Rob Douglas, the COO of ResMed. 

Rob, I think you commented after the results that you’re actually increasing market share despite the increase in competition that you’re facing.  Is that market share growth coming at the expense of price? 

No, I wouldn’t say that.  It’s more profound than that.  A few years ago, ResMed – we took a strategic decision to make sure that pretty well every device that was manufactured, was connected.  And by connected, it had in it a 3G or similar chip so that when the device was really provided to a patient to use, when it was plugged into the wall and turned on then the device would connect.  What that connection did was every morning, pretty well an hour after patients had finished sleeping, would upload the data of how well the device performed, how well the patient slept, were there any problems?

We have that data come into our system now every day and we actually have about 5 million devices connected at the moment every day providing that data and we’re now have about 2.5 billion nights’ of information.  What we do with that information is we package it up and provide it back to the patient to help them stay with their treatment or back to the provider to help them manage the patient.  Our data shows that you get much better outcomes in terms of ongoing usage of the machine at a lower cost, so it’s a real value-add.  Our customers really got the value proposition of all of that and that’s really driven sustained market share gains in many, many markets.  

Was that to do with the acquisition of Brightree in 2016.  No, actually, this was all happening before and in parallel with that.  In doing this we were building a huge software capability and running really a large connected device.  It’s the largest network of connected medical devices in the world and we build a whole lot of software capability and in a sense what we were doing was providing ways to improve and automate the workflows for home medical equipment providers to manage patients. 

We had worked over the years with Brightree and knew them quite well and they were providing cloud based software services to help HME providers manage their business, so it was more business managed software.  In a sense it made good logic to combine those two things.  Really strong capability in patient management and front end management, with a really strong capability in business management and back-end business and together we add value.  These HME customers are not just treating sleep apnoea patients, that’s a major part of their business.  But they also do things like provide oxygen ventilation, mobility products that type of thing for people who have chronic diseases and need long term care. 

Perhaps you could help us understand the business model, because I’m looking at a chart now of the division of your revenue.  Devices – 56%, masks – 37%, Brightree 7%.  That indicates or suggests that Brightree remains separate as a business rather than integrated into your – and it also suggests that you’re still making most of your revenue from selling devices, is that right?

That’s exactly true and largely because of that increased market share in the device business, it’s a very strong business.  Quite a few points here.  One is, we recently released a study at the American Thoracic Society that looked at prevalence of sleep apnoea around the world and a group of peer opinion leaders and medical experts looked at studies and produced a report that suggested there were 936 million sleep apnoea patients around the world.  Most of them are untreated.  Treating those patients is and will remain a very core part of our business.  With regard to Brightree as I mentioned earlier, they’re supporting the entire business of our home medical equipment provider customers including not only sleep apnoea patients but CIDP, chronic lung disease patients. 

People who have mobility issues.  Many, many other areas, some are in dialysis even.  Brightree supports all of those.  Those customers also in fact may be providing our competitors products as well and if you think about it, we need to keep Brightree as a very separate business and a separate brand and we actually have firewalls in the business regarding information flows as well.  We’ll continue to invest in Brightree.  It is a US business and it’s very focused around home medical equipment providers. 

But that software as a service for out of hospital healthcare providers is a very interesting area and Brightree has other emerging businesses in that area and in fact we also just closed an acquisition of a software as a service company called healthcare first who provide software to businesses that are really doing home nursing and home care visits and how do you manage all the information that you have to gather when you’re going to visit a patient in the home.  That’s an emerging business for Brightree. 

I got the impression, perhaps wrongly, that what you were doing was shifting the whole business model of ResMed away from device and mask sales towards the recurring revenue from software as a service.  But it sounds like the data that you’re doing is actually to support sales?

It’s both.  Look, it’s complementary.  We believe that from having the close connection with the patients, with the devices and particularly the masks and also the information about what’s going on.  You can then feed that into the software as a service business and a cloud based business and really create huge value by merging the two.  The type of value that you might have is, if someone uses our automated connected patient follow-up system, our typical compliance rates – and compliance is whether or not someone uses the system for a long period of time – will go from high 50s and 60% - they’ll go up into the high 80s.  It’s really like a 25% improvement in compliance.  In the US for example, you can only build many of the insurance companies once you’ve proven that the patient’s using the machine.  That’s a huge difference.

That compliance rate is much better than you’ll get with any typical medicine over the long term and what we’re really doing is taking a non-trivial homecare treatment and making very accountable to that.  We really see the synergy between those software businesses and our traditional business as well and we’ll continue to invest and build in both.

Can you tell us about the competitive situation you’re facing now?  Because I think that Philips has launched a mask and Fisher & Paykel have also come into the market.  How many competitors are there now?

There’s only a couple of global competitors and really between ResMed as the market leader and Philips, we cover a vast majority of the market.  S&P are also in the mask space as well.  There are other local competitors but none of them have any form of global scale that we see and in a sense they’re less competitive now than they were 10 years ago.  But nobody’s complacent in this industry, it is a competitive industry and you’ll see a lot of people talking about product releases and we really drive our product portfolio quickly.  We’ve got a very intense R&D program that we invest in and we’ve added onto that investment a lot of software investment and we keep pursuing masks. 

Just the last quarter we released a new feature on our two main masks that was a new vent.  The device has actually let air blow out, it was called the quiet air vent.  That really reduced the noise that was created by the mask by 89%.  Our F20 and M20 mask range now is not only the most comfortable and best sealing mask, they’re also the quietest by a mile and we’ll compete on those product features.

A lot of the analysts in looking at your results are focused gross margin and there’s a fair bit of divergence.  Some people are adjusting it for currency.  What do you do?  How do you look at gross margin?  Should investors adjust it for currency and what is the trend over say the last five years for your margin?

Gross margin’s been an important metric for the company.  We think people should look at our overall operating margin which has shown some very good improvement recently.  With regard to gross margins, there’s sort of multiple factors in there that come into play and they get looked at quite closely.  Number one issue in terms of margin obviously is what prices you achieve in the market.  Remember I talked about the 936 million patients that need treatment?  Generally, there’s huge patient inflows into the health systems, which would lead people to see treating sleep apnoea as a sort of an increase in cost category and so there is per patient cost pressure across the whole system that eventually translates to pressure on our prices. 

That per patient cost pressure is a reflection of increasing patient inflows and more than offset by volume growth.  Other factors on the margin, we run a really strong supply chain around the world and we’ve got a very good team focused on optimising the cost of manufacturing the products and we’re continually improving that.  As you’ll see in any electronics and volume manufacturer, we’ve got a significant volume scale in the business as well and then there are other factors.  Some countries have lower prices than other countries, so we have higher margins in some countries than others and some products have different margin profiles.  Depending on the product mix and what country’s growing or whatever, we’ll see different pressures in the margins.  Currencies are a factor but it’s not simple, we report in US Dollars, we have a good quantity of sales in euros and a good quantity of cost in Aussie Dollars.  If the euro and the Aussie Dollar are roughly in sync versus the US, it doesn’t make much difference.  If the Aussie Dollar changes from the rate versus the euro – that cross rate that’s actually more worth watching about if you’re interested in subtleties of foreign exchange impact on ResMed. 

I don’t want to get into too much detail.  I suppose one of the things that really sticks out about your business is the conversion of your profit into cash – tremendous, huge!  What is your cash conversion ratio?  It’s enormous.

We’re a very strong cash generating business.  Part of the factors there, it’s not a large capex business in any means.  It’s got pretty R&D and we do need to have a very focused sales process and provide very strong support for it.  Really, other than that it’s not a high capex business.  We do have some long supply chains with our manufacturing platforms in Australia and in Singapore and a lot of our inventory is actually on sea containers in freight, so there’s a few issues around working capital.  Other than that, we’ve got a very strong cash conversion rate.

Your gross profit I think for the year, was $1.36 billion, total income after expenses $542 million or so, and then cash flow of more than $500 million.  

Yeah, we’re proud of that and we’re able to keep doing that.  That then subsequently reflects through into the balance sheet.  We run very lean on debt ratios and things like that as well.

Does that suggest that you’re under-spending on R&D?  Because you’re obviously going to be coming more and more under pressure to innovate, given the competition that’s coming.  What are your intentions re R&D.  I note that the spending in the latest year was $155 million, is that going to have to increase?

Typically, it’s been around 6-8% of sales over the years and we don’t give a lot of guidance, certainly not top or bottom line but we have said we’d foresee the R&D expense to continue in the 6-7% range.  And you raise a very good question, could we invest more and drive the technology faster? As we look at it we think we’ve roughly got the right setting on that, although as you point out, we’ve got the capability to accelerate where we need to.

The way you’ve managed the capital has been through a lot of share buybacks, which I presume has to do with the lack of dividend franking for Australian investors, would that be right?

Yes, although, it’s a mixture of things.  Obviously, just given the global nature of our product of our business and we’re not able to provide franking, many of the investors, remember, are US-based.  We’ve got quite a few based in Europe, Asia also – there’s a global perspective on that.  We’ve got a continuing dividend policy.  We’ll continue to grow the dividend as our bottom line grows and keep that running and then as appropriate, we will do share repurchasing.  Some of the share repurchasing – and it’s about the current rate, we tend to offset any employee equity compensation issues that will offset the dilution effect of that. 

But other than that, we like having the option of having a strong balance sheet and the capability to make any moves that need to make as opportunities arise, and be very prudent with our shareholders cash and return it as appropriate.

Just finally, I mean obviously for investors the main issue is trying to get your head around a PE ratio in excess of 40 times on a trailing basis, but also looking forward even it looks like it’s going to be, the current price 35 times revenue in two years’ time.  Just getting your head around that kind of growth rate required…  Do you think that ResMed can continue to produce the sort of growth rates it’s had given the way the market is changing and I presume the basis of your optimism for it would be on the growth in diagnosis of sleep apnoea and treatment of it, which as you say, remains a fairly small percentage of the number of people who’ve got it. 

Yeah, we’re playing in a very underpenetrated market where people have taken – we’ve been evangelising the importance of treating sleep apnoea for many years.  It’s now very well known in most developed markets.  I’m not sure that the healthcare profession and the sort of health system players fully understand the consequences of untreated sleep apnoea and we would make the hypothesis that untreated sleep apnoea cost you more than it does cost to treat it.  Providing that data is not easy and we do invest in those types of trials and studies to keep trying to do that. 

We talk about market growth rates in the sleep and in our core businesses of mid to high single digits, very broadly around the world and then we talk about ResMed’s ability to meet those market growth rates and perform better than those in areas, and that’s just in the core businesses.  Then we to have other areas that we invest in, adding in software and the capabilities around that.  We’ve got a really good team working on CIPD which is another whole area that not everyone knows we’re involved in but there’s over 360m CIPD patients around the world.

What does CIPD stand for?

CIPD is Chronis Obstructive Pulmonary Disease.  In some places, emphysema is one form of it.  People who smoke can get it, people who live and work in polluted environments can get it and it’s a long term chronic disease that starts off with breathlessness and ends up with really severe inability to breath.  But that’s over a course of many, many years.  These patients are typically treated at home and we’ve invested in a number of treatments for these patients including our home ventilators, our non-invasive ventilators, and also including oxygen therapy.

We acquired a company a few years ago and we’ve just this year started to control market launch of a ResMed branded device that’s called a portable oxygen concentrator.  In a sense it’s a small device that you can carry over your shoulder that provides oxygen therapy for you while you’re walking around going to the shops or whatever.  We think being active when you’ve got these conditions actually provides better outcomes for you.  But those are additional treatments that will help grow our business beyond those markets.

I know I said, finally and I’m sorry, but I’m just picking you up, you said you’re looking at market growth of mid to high single digits?

Yeah.

Your growth is actually twice that, I think, which is why I started the interview by talking about how your market share must be growing.  Are you saying that you can continue to grow at double digits yourself despite the market growing at less than that? 

Alan, naturally you’ve got to be careful giving direct growth forecasts and that type of thing, so it again just reverts back to the fact saying that that market growth, mid to high single digits – and sometimes that’s higher than that – we should be able to, with our ability to execute and the global team that we’ve got, be able to continue to win share and continue to grow faster than that.  Meanwhile, with our investments in software and our organic developments now that we’re doing on software and our investments into treating CIPD and providing ventilation and oxygen therapy amongst other things should give us ability for growth beyond that.

Great to talk to you, Rob, I appreciate it, thank you.

Great, thank you, Alan.

That was Rob Douglas, the COO of ResMed.