F&P Healthcare: Show us the money

One year ago on 11 May 2011 we upgraded Fisher & Paykel Healthcare to Long Term Buy at a price of $2.19 in F&P Healthcare: An awakening. The share price has fallen 30% since then, as you can see in Chart 1, so let’s re-check the story now the 2012 annual result has been released (the company has a 31 March year end).

Before turning to the nuts and bolts of the result, though, let’s briefly recap the investment case.

First, markets for acute respiratory and obstructive sleep apnoea (OSA) products are growing quickly, so earnings should follow. We expected earnings could grow at 12-15% a year for several years.

Second, profits aren’t sensitive to economic conditions, which helps diversify your portfolio compared with more cyclical buy recommendations like Computershare or Macquarie Group.

Third, Fisher & Paykel Healthcare will be a major beneficiary of a lower Aussie dollar, as the company earns almost 80% of its revenues in the US and Europe. Overseas exposure helps build a robust portfolio (see Why I can afford mistakes (and maybe you can't)) from 25 May 12.

Finally, management is shareholder friendly and pays out most of the company’s earnings as dividends.

Annual result

So how did the result look? Revenue increased only 2% to NZ$517m, but growth was 12% in US dollar terms. Reported net profit was flat at NZ$64m, but it increased 10% in US dollars. Europe was the bright spot—surprisingly—producing 7% growth in NZ dollars and 18% in US dollar terms. Underlying earnings growth has been decent enough, but not exactly stellar.

Earnings per share was NZ$0.124. Converting to Aussie dollars, that’s the equivalent of $0.094, so the price-to-earnings ratio of 18 is still lofty. The final dividend of NZ$0.07 (ex date 18 June) was held steady, while eligible non-New Zealand resident shareholders will receive a bonus dividend of NZ$0.01235 in lieu of imputation credits. That puts the company on a 6.3% unfranked dividend yield.

The sleep apnoea division was the weakest link, with underlying revenue rising by just 7%. While flow generator (machine) sales increased 18%, mask sales fell 4%. Competitor ResMed has been taking market share in masks, although Fisher & Paykel Healthcare is fighting back with a range of new masks currently being released. The result compared poorly with the acute respiratory division, which produced 18% underlying revenue growth.

In 2013, management expects ‘underlying revenue growth to begin to accelerate this year, particularly in the second half, as a number of new products, including new OSA masks, are introduced around the world.’ Profit margins should also increase ‘with faster growth in higher margin differentiated products, cost reductions and other efficiencies’. The new manufacturing plant in Mexico, which is now producing a larger range of products at lower cost, should help here.

Rosy outlook, lousy forecast

Despite the rosy outlook, the company is only forecasting a net profit of NZ$62m-$70m this year. That’s potentially less than the NZ$64m profit produced in 2012, which was severely impacted by unfavourable currency movements.

This conflicts with our initial investment case, which called for fairly predictable earnings growth of 12-15%. The question is, does 2013 mark a temporary slow down in Fisher & Paykel’s earnings or a permanent one? If the company can only grow earnings at 10%, then it’s currently fairly valued and our original recommendation was a mistake.

According to management we’ll have to wait until the second half of 2013 to find out. That being the case, we’re reducing the prices in the recommendation guide and switching back to Hold until the company shows us the money. We’ll be watching mask sales (and those of ResMed) too, as they produce around three quarters of the sleep apnoea division’s profits.

Premature accumulation

If you followed our original upgrade, there’s been little share price joy. History may show that we suffered from ‘premature accumulation’, as US investor Bruce Berkowitz calls it, but it’s too early to pass judgment yet.

The fact is that Fisher& Paykel Healthcare is producing underlying revenue growth that most management teams would kill for in the current economic environment. Provided the New Zealand and Australian dollars hold steady or weaken, then the company’s progress should be clearer in the 2013 reported results.

Warren Buffett says that ‘time is the friend of the wonderful company, the enemy of the mediocre’. Provided Fisher & Paykel can defend its market position as it has done for decades, and given the company pays decent dividends, we can afford to be patient.

The share price has fallen slightly since F&P Healthcare’s headwind from 1 Dec 11 (Long Term Buy – $1.77) and we’re downgrading a notch to HOLD.