ResMed: Pain and pleasure of US tax reform

‘Transition tax' doesn't sound very pleasant, and it isn't. Previously, US companies often left their foreign-earned profits in the countries where they originated to avoid paying taxes in the US. In December, however, the Trump administration passed a law that deemed all international earnings to have been repatriated to the US. Any untaxed foreign earnings held as cash were hit with a one-time 15.5% transition tax, and remaining earnings taxed at 8%.     

These changes will impact many Australian companies this reporting season – such as Ansell, Computershare, CSL, and BlueScope Steel – so it's important to gauge the fallout.

The first company on our roll call is ResMed, which has recorded a US$120m tax charge associated with the new law. Given just US$141m of pre-tax profits, it's no small matter.

Patriot games

There is a bright side, however. While the transition tax is large and unexpected, it's a one-time charge and was necessary to get some far friendlier tax changes passed by Congress. The first was the implementation of a ‘territorial tax system', where taxes are only imposed on domestic profits, not foreign-source income.

For example, when ResMed sells an oxygen generator in France, it will now pay taxes in France itself and then be able to bring the after-tax profits back to the US without paying additional taxes.

This gives large multinational companies significantly more flexibility. Prior to the change, it was difficult (or at least costly) for ResMed to earn money overseas and then bring it back to the US where it could be invested in research or other centralised operations. This had a curious effect: many multinationals would be swimming in cash on a global level, but have to raise debt in the US to pay for local expenses. Apple is a prime example. It has US$252bn of cash held in foreign subsidiaries, yet needed to raise US$97bn of mainly US-denominated debt to pay for local infrastructure and research.

The switch to a territorial tax system frees up ResMed's international cash (over US$700m) for investment in US growth opportunities, acquisitions, or other capital management plans. All things being equal, this extra ‘fluidity' between geographies should mean a cleaner balance sheet over the long term as there's less pressure to use debt to pay for US expenses when local cash flows won't cover the bill.

Stock more valuable

The second part to US tax reform is a reduction of the corporate tax rate from 35% to 21%. Shareholders like to think of themselves as the sole owners of a company, but there's always a hidden alpha shareholder in the shadows – the Government. Until now, the US Government was entitled to a 35% stake in a company's profits, and ordinary shareholders would get the remaining 65%.

‘The Tax Act is a huge factor in valuation,' Warren Buffett recently said on CNBC. ‘You had this major change in the silent stock holder in American business who has been content with 35% ... and now instead of getting a 35% interest in the earnings they get a 21% and that makes the remaining stock more valuable'.

Common shareholders of ResMed are now entitled to 22% more of every dollar the company earns. Given that any tax-driven boost to the profit margin will probably erode over time due to competition, it's imprudent to simply slap on an extra 22% to ResMed's valuation. Nonetheless, ResMed is more valuable today than it was a month ago due to the reduced US corporate tax rate.

ResMed's statutory net profit plummeted from US$76.7m to US$9.5m for the three months to December, but the poor result was entirely due to the US$120m transition tax. Over the long-term, the benefit from lower corporate taxes will far outweigh this one-off charge.

Underlying result

Stripping out all the tax shenanigans, ResMed posted a good result for the quarter. Revenue increased 13% to US$601m, and was up 11% after removing the effect of currency fluctuations.

The result was buoyed by strong sales of continuous positive airway pressure (CPAP) devices and masks in the US, Canada and Latin America, where revenue rose 12%. The company's high-growth software business, Brightree, increased revenue a hearty 14% to US$39m.

Moving down the income statement, we hit a snag at the gross profit line, where the margin contracted from 58.3% to 58.2% due to a decline in average selling prices.

ResMed has suffered several years of declining prices and rising competition, but this seemed to have run its course earlier in the year (see The ResMed result we've been waiting for). The turnaround in the gross margin is disappointing but we won't lose sleep over 0.1 percentage points. The current margin is still well above the low of 57.3% earned last year.

Thankfully, this small blemish was more than offset by improvements in selling, general and administration expenses, which rose 6% on a constant currency basis. As sales growth outpaced operating expenses, earnings before interest and tax (EBIT) rose 51% to US$146m, showing off the company's operating leverage (which, we should add, can also work in reverse).

As a proportion of revenue, administration expenses have declined from around the 30–32% mark a few years ago to 27% today, and management believes it can get that figure below 26% in the next year or two. Management was optimistic that profit growth would continue to outpace revenue growth in future years, with chief executive Mick Farrel saying ‘there's a lot of runway ahead'.      

Underlying net profit rose 39% to US$143.8m and the stock trades on a forward price-earnings ratio of 31 based on consensus estimates for 2018 earnings.

We're raising the price guide to reflect ResMed's improving operations and the US tax changes, but the company is still closer to a downgrade than an upgrade. If the stock has become a large slice of your portfolio, you should consider taking some chips off the table in favour of the better opportunities on our Buy list. HOLD.