How ResMed is still hitting sixes

Consistent attention to its cost base and a robust R&D pipeline has kept ResMed in good financial shape.

Summary: A clarity of focus on sleep apnea products and keeping its costs trim gives ResMed plenty of ammunition to take on new competitors. If only the Australian cricket team could be so consistent.
Key take-out:  With a $1 billion cash stockpile, and good profit margins, ResMed is well equipped to compete with industry newcomers.
Key beneficiaries: General Investors. Key Category: Growth.

Australians are passionate about their cricket, yet even true-blue supporters are looking to the 2013 Ashes campaign with a sense of dread. Aside from Michael Clarke, the team seems at a loss for consistent performers of a high quality.

Bring back the turn of the 21st century when the Australian team dominated world cricket! There was such an amazing pool of talent – Langer, Warne, Waugh, Ponting, McGrath, Hayden, Gilchrist, Healy – that the selectors were spoilt for choice if a team member was unable to play.

Apologies to those readers who are not cricket fans, but the analogy has context for the business world. You see, management often finds itself in a similar predicament – one area of the business may perform exceptionally well while other areas perform poorly. It is rare for a company to demonstrate strong metrics consistently across each area of its operations.

But there is one company that has such strong fundamentals that management is spoilt for choice with the number of levers that can be pulled in order to maintain exceptional returns. Indeed, the company has just announced its 73rd consecutive quarter of earnings growth!

ResMed manufactures equipment to help sufferers of Obstructive Sleep Apnea (OSA). OSA is a condition that causes the airways to temporarily close while sleeping (apnea means “without breath”). The beauty of ResMed is the clarity of their financial metrics, which provides investors with a clear awareness of the company’s financial position.

First, let’s discuss ResMed’s revenue drivers. ResMed generates the majority of its revenues from mask sales and flow generators (machines that regulate the patient’s airway pressure during sleep). Historically, revenues have increased by 20% every year for the past decade.

However, this growth has started to moderate, and mask sales in particular have been soft outside America in the latest quarterly report. This is partly due to two competitors (Fisher & Paykel and Philips Respironics) releasing new masks during the quarter. So what can management do to invigorate sales?

ResMed has a dedicated research division that has developed such a strong pipeline of products that management can launch a new range when sales of existing products begin to lag. Management has announced that it will introduce two new masks in the fourth quarter, along with many more products in the coming financial year.

Next, let’s look at ResMed’s amazing gross profit margin – this is the residual of sales minus cost of goods sold. The gross profit margin has historically been above 60% – as a comparison, Philips has a gross margin of 40% on a firm-wide basis. Despite softening sales, ResMed achieved a gross profit margin of 62.4% in the third quarter!

This margin expansion can be attributed to management shifting the manufacturing base to Singapore – total production in Singapore has risen to 60%. Along with a decreasing cost base, moving production to Singapore also frees up ResMed’s working capital and provides an effective tax rate of 21%.

So if ResMed’s top-line growth is expected to fall, management has the capacity to shift a greater share of manufacturing to Singapore in order to maintain margins.

There are two other levers that management has at their disposal to manage the bottom line. Research and development (R&D) is a critical expenditure for ResMed as it is necessary for the company to maintain its competitive advantage of producing superior products. While management has stated that R&D is not managed according to a specific benchmark, the market has come to expect that 8% of sales is directed towards the division.

Management has more discretion over Selling, General and Administrative (SG&A) expenses in order to manage earnings. Indeed, ResMed has established such a large sales force and referral network that SG&A expenses have gradually fallen to 29% of sales.

Finally, ResMed has an amazing stockpile of cash – $1 billion in fact. Management does not appear inclined to use the funds for an acquisition, instead preferring to buy back shares. While this does not improve the core profitability of the business, it can be used as a temporary measure to lift ResMed’s earnings per share in periods of underperformance.

I am as comfortable holding ResMed today as I was back when I purchased the shares. A company with strong financial metrics across the board is able to insulate their earnings from future shocks far more effectively than one that relies on a few key drivers.

You only need to look at the state of Australian cricket to see how the outperforming areas of an organisation can only support the underperforming areas for so long. Let’s just hope that Cricket Australia’s painful (and likely prolonged) restructure will restore some glory of old.


Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com