ResMed's price war continues

On today's earnings call, chief financial officer Brett Sandercock shared the good news: ResMed's gross margin expanded one percentage point to 59.2% due to the recent acquisition of MatrixCare, which has higher margins than ResMed. This more than offset 'typical declines in average selling prices' for the company's continuous positive airway pressure (CPAP) machines and masks. 

That last line has been repeated, word for word, 12 results in a row. For all ResMed's free cash flow, revenue growth and fancy software acquisitions, the word 'typical' is what anchors our enthusiasm.  

Michael Porter's 'five forces' explain why. Porter believes that a company's competitive position can be boiled down to five factors and how they relate to each other: the bargaining power of suppliers and customers, the threat of substitute products and new companies entering the industry, and the intensity of rivalry between competitors.

ResMed scores well on most of those factors. The company's economies of scale give it a strong arm in negotiating with suppliers. Indeed, 'procurement efficiencies' also contributed to this quarter's higher gross margin. ResMed used its size to squeeze suppliers for better pricing on raw materials and parts. 

As for substitute products, ResMed's CPAP machines do have a few, such as oxygen generators and oral appliances, but CPAP is the gold standard for moderate to severe cases. 

What's more, the sleep apnea industry is an oligopoly, with ResMed, Fisher & Paykel Healthcare, Philips Respironics and CareFusion accounting for 90% of the market. High regulatory oversight and research budgets create a barrier to new companies setting up shop.

On the whole, ResMed is in a cosy position and earns a profit margin of 16% and return on capital of 20%. 

Angry oligopoly

It's the last of Porter's forces - intensity of rivalry between competitors - that continues to be a sore point for ResMed and its shareholders. Over the past five years, the company's revenue has grown at 11% a year, but it has led to net profit growth of a mere 3%. A price war between the competitors mentioned above has been a big part of it. 

The lacklustre profit growth is despite management's strong track record of cutting costs. Over the past five years, several programs to cut head office and selling expenses helped to reduce administrative costs from 32% of sales to just under 25% this quarter - the lowest expense margin going back to 1994. Given where revenue is today, that's over $100m worth of 'efficiencies' carved out since 2014.

The cost of manufacturing masks and CPAP machines - and running the company generally - has been falling. Unfortunately, ResMed has been cutting price tags even faster. Average selling prices have been declining for the better part of a decade - top machines cost half what they did 10 years ago. 

Brand loyalty is thin in this industry. When a patient gets a Cochlear implant, they're locked into buying sound processors from the company for decades. This means Cochlear can keep raising prices and ensures excellent margins. 

That isn't the case for CPAP makers. Masks are compatible with machines from other manufacturers - an F&P Healthcare mask can be used with a ResMed machine and vice versa.   

The four firms that dominate the sleep apnea market are evenly matched on many factors, such as product quality, breadth of distribution, market share and research capability. No matter how many touch screens and comfort options ResMed adds to its CPAP machines, its rivals are adding bells and whistles just as fast. Offering the lowest price is often what makes the sale. 

Strong sales growth

ResMed has been fighting this trend with an interesting strategy: make life easier for health care providers, not only the patient. Happy gatekeepers, the theory goes, will lead to more referrals to other ResMed products.  

Software revenue doubled this quarter compared to last year thanks to growth in the Brightree business and the recent acquisitions of MatrixCare and HEALTHCAREfirst. These companies provide a smorgasbord of software solutions to doctors, nurses, care homes, and hospitals to help with patient monitoring, billing and practice management.

The ultimate goal is to integrate ResMed's well-liked Air Solutions platform with the work flow functionality of these auxiliary software providers to improve efficiency for healthcare organisations.

While the software strategy doesn't seem to be curbing the price battle between CPAP providers, it may still be convincing a few extra customers to buy ResMed's devices and masks. Revenue grew 15% excluding the effect of currency fluctuations to US$662m for the three months to March. Sales from North America increased 10%, driven by strong demand for the company's new masks and CPAP machines. 

Combined revenue from ResMed's other markets - Europe, Middle East, Africa, and Asia Pacific - increased a more modest 6% in constant currency terms. The result was fuelled by strong demand for the company's masks, though this was partially offset by declining device sales in France and Japan, where Government-funded upgrade programs ended.

Unfortunately, the revenue growth and contribution from new acquisitions didn't translate into profit growth, with net profit down 4% to US$105m due to higher interest and tax expenses.

More research

A further drag was a 26% increase in research spending, which rose from 6% of sales to 7%. However, given falling selling prices and the ferocity of competition, this is one expense we're happy to see increase.

Several new products were released this year and the company launched the new P30i mask last month. This new 'tube-up pillow' mask option is said to be an improvement on previous masks by offering more freedom of movement and a more comfortable fit. 

ResMed's stock trades on a forward price-earnings ratio of 29 given consensus estimates for 2019 earnings. While we're pleased to see strong revenue growth, price competition and the lack of profit growth is a worry. ResMed's high price-earnings ratio is usually reserved for companies with rapidly growing earnings per share, but so far that's more hope than reality for ResMed. We're raising our price guide slightly but there are better opportunities on our Buy list. HOLD.

Note: The Intelligent Investor Equity Growth Fund owns shares in ResMed.