ResMed: breathe deeply & buy

It’s quite possible that ResMed's senior management are huge fans of Arthurian legend and Monty Python. Their constant talk of the ‘holy grail’ refers to the pinnacle of healthcare provision, combining improved quality of life, slower disease progression and reduced healthcare costs.

Plenty of medical treatments increase quality of life and slow disease progression, but at huge cost. Sirtex Medical’s SIR-Spheres, for example, can extend the life of those suffering from advanced liver cancer by several months but cost more than $10,000 to do so.

ResMed, on the other hand, actually saves the healthcare system money by preventing people from getting sick and keeping them out of hospital. How? By providing machines, masks and other paraphernalia to treat sleep disordered breathing, most particularly obstructive sleep apnoea (OSA), which raises blood pressure and is linked with an increased incidence of heart disease and diabetes.

OSA occurs when the airway collapses during sleep, interrupting breathing and causing sufferers to wake momentarily (an event known as an apnoea). Deep, restorative sleep is beyond them. OSA machines increase the pressure through the airway to keep it open, reducing the debilitating effects of sleep deprivation and these more serious illnesses.

ResMed, like its main competitor Philips Respironics, has about 40% of the OSA treatment market. ASX-listed Fisher & Paykel Healthcare, on which we have a Hold recommendation, is in third place with about 10%.

ResMed’s market share in masks slipped during the third quarter due to the timing of product launches, but its market share in machines has been increasing, helped by a move towards home sleep testing, which now accounts for about a third of OSA diagnoses.

Home sleep testing avoids an overnight stay at a sleep lab, but it provides less accurate data on required pressure levels. This plays to ResMed’s strengths in high-end machines, which offer variable pressure control and enhanced data collection through the company’s EasyCare Online package.

Competitive advantages

As new chief executive Mick Farrell explained in Friday’s conference call, however, the company’s main obstacle isn't competition but the lack of understanding and awareness of OSA among healthcare professionals.

Farrell estimates that around 5%-15% of the company's core sleep-disordered breathing market has so far been reached, ‘meaning that 85%-95% of the opportunity in our core business is still in front of us’. Healthy competition can be a positive in such a market because all market participants are working to educate the market, thereby boosting overall growth.

That said, ResMed does enjoy competitive advantages, through its brand and relationships with distributors and healthcare professionals, and its technological edge in variable pressure machines and data collection. These are the product of the company’s huge research and development (R&D) spending, which has been running at about $10m a month so far this year, equivalent to more than half of third-placed FPH’s entire OSA-related revenue.

R&D spending has also taken ResMed into neighbouring markets, such as chronic obstructive pulmonary disease (COPD), for which the company announced a new FDA-approved machine alongside its third-quarter results.

This is a highly attractive market, and not just because it’s the third most common cause of death in the developed world (after heart disease and stroke). COPD is very expensive to treat. ResMed estimates that the US market for its COPD machines could be around $100m and it expects to get ‘more than its fair share’ of that.

A longer-term opportunity is in heart-failure patients, who often suffer from central sleep apnoea, in which a neurological malfunction can interrupt breathing. In addition to the usual problems of sleep deprivation, central sleep apnoea can be fatal.

ResMed will soon complete enrolment on a two-year trial to test a machine specifically designed for heart failure patients. With an estimated six million people suffering from heart failure in the US alone, it’s a huge opportunity. The company is ‘cautiously optimistic that the data [is] going to show ResMed’s proprietary technology can save both lives and money’.

Competitive bidding lost in wash

The company also took the opportunity on Friday to provide some comfort over the CMS competitive bidding in the US, the announcement of the second round of which saw ResMed’s shares fall about 8% on 31 January.

The company noted that only 10%-12% of revenues were directly affected and said the price cuts were likely to push overall annual reductions to the top end of the 3%-5% range it normally expected. But, against this, it said it aims for 5% of cost savings every year and that this process would continue. Overall, the impact of competitive bidding is a small negative, but we expect it to be lost in the wash of the company’s growth.

This was a respectable third-quarter result, in line with immediate expectations but providing plenty of confidence for the future – certainly justifying at least the ‘middling’ valuation scenario outlined when we upgraded the stock on 25 Jan 13 in ResMed’s dream run continues (Long Term Buy – $4.52).

The share price is up slightly since then and, in line with our new approach to recommendations, here’s an example of a recommendation that changes to Buy. We’re also increasing our maximum portfolio weighting to 7%, although bear in mind that ResMed’s earnings come from only one product area, so conservative investors might choose a lower limit. BUY.