This time last year, ResMed’s management said it expected gross margins to improve in 2016 due to a higher volume of products being made using the same fixed manufacturing lines, as well as a cost-saving shift towards using more sea freight rather than air freight.
Instead, the company’s gross margin fell from 60% to 58% – its lowest since 1996. The main culprit was fewer sales of high-margin products and lower prices across several product ranges. The prices of masks, in particular, have been in a downward trend over the past few years due to strong competition from the likes of Fisher & Paykel Healthcare. There's an arms race going on, with competitors vying to produce masks and continuous positive airway pressure (CPAP) machines that are easy to use, comfortable and cheap.
Gross margin still shrinking
R&D spending on the rise
Valuation on the high side; Hold
Significant research spending is necessary if you want to keep your products competitive. With this in mind, it was good to see that spending on research and development (R&D) increased 24% to US$34m in the fourth quarter, representing 7% of revenue. That’s not quite the 9% of revenue that F&P Healthcare allocates to R&D, but we’re pleased to see more being spent in this area after falls in each of the last two years.
Total revenue for the year to June rose 10% to US$1.8bn, which was a 13% rise after removing the effect of currency fluctuations. The result was mainly due to strong sales of masks and devices, particularly in the Americas, but it was also helped by the inclusion of Brightree, the software business acquired earlier this year which added US$30m (about 2%) to revenue.
Were it not for the shrinking gross margin, that would be a perfectly respectable result, but with costs growing faster than revenue – combined with various one-off expenses related to the acquisition of Brightree and Inova – net profit was unchanged from the year earlier at US$352m. Even after removing all the one-off expenses, underlying earnings per share grew a paltry 4%.
ResMed shares have almost doubled since we originally upgraded the stock to Buy on 26 Jan 13 (Long term buy – $4.52), but it hasn't happened how we expected. Current forecasts for US$ earnings per share in 2017 of US$2.97 are below even the pessimistic assumption of US$3.15 in our initial analysis, and well below our US$3.46 central case. The saving grace has been the lower Aussie dollar, which means 2017 earnings are likely to be worth around 40% more to Australian investors.
The theory back in 2013 – as now – is that only around 20% of sleep apnea sufferers are receiving treatment, giving ResMed a large, untapped market growing at 5–8% a year. Everything went well for the first couple of years, with revenue rising 14% and net profit up 35% between 2012 and 2014. But in the two year's since, the tables have turned. Revenues have continued their growth – rising 18% – but costs have risen faster, crimping margins and restricting net profit growth to just 2%.
This is particularly ominous because sales growth may be harder to come by in future. As of 1 July, US Medicare reimbursement rates for sleep therapy products – such as flow generators and portable oxygen concentrators – were reduced by about 14%. This follows a 45% fall in 2013. Cuts to Medicare reimbursement increase a patient’s out-of-pocket expense, which makes it difficult for ResMed to raise prices.
Market share growing
|Year to 30 Jun||2016||2015|| /(–)
|EPS* (US cents)||24.9||24.7||1|
|Final dividend||3.3 US cents, unfranked, (up 10%),
ex date 16 Aug
|*US cents per ASX-listed CDI|
To be fair, ResMed’s revenue growth has been slightly ahead of the overall market, which means the company is increasing its market share. There are plenty of economies of scale in this business – especially on the software side – so increasing market share at the expense of profits in the short term may actually be quite a sensible strategy – so long as it truly is a short-term manoeuvre.
Unfortunately, we’re not sure that it is. Government budgets are strained, so we expect continued pressure on Medicare reimbursement rates. What’s more, the big dream of expanding the market's size will be a slow grind. Those patients with the most severe sleep apnea – those for whom ResMed adds the most value – are mostly already being treated. They're the low-hanging fruit. The untapped market will likely have less severe symptoms and will almost assuredly show lower rates of compliance (thus fewer replaceable mask purchases) and require more costly marketing to get on board.
With this in the back of our mind, the US$800m purchase of Brightree – 19 times its 2015 earnings before interest, tax, depreciation and amortisation (EBITDA) – has a faint whiff of desperation. Chief executive Michael Farrell said: ‘ResMed is on a trajectory to be the world's leading tech-driven medical device company’. The company will need to do better than 2% profit growth, or it’s going to be a very slow ride.
ResMed trades on a price-earnings ratio of 27 and an unfranked dividend yield of 1.9%. Were it growing in the high single digits, today’s price would look perfectly reasonable, but it’s becoming harder to justify a high price-earnings ratio without that growth materialising.
ResMed is a high-quality, profitable company with a clean balance sheet and is a leader in its industry. Despite the mainly negative tone of this review, there’s still a lot to like.
We’ll leave the price-guide unchanged for now, but ResMed is getting close to our Sell price and is on our watch list for a potential downgrade. Given the price increase, the stock may have become a large portion of your portfolio. If that's the case, you should consider taking some chips off the table in favour of the better opportunities on our Buy list. Otherwise, HOLD.
Disclosure: The author owns shares in ResMed.