ResMed takes a breather

Investors have got used to pleasant surprises from ResMed results, so the savage reaction to the disappointing first-quarter performance is unsurprising if somewhat excessive. The stock fell 8%, taking it back to where it stood when we wrote up the final result in ResMed: Result 2013 on 2 Aug 13 (Buy – $5.46), despite a 7% rise in the All Ords.

It wasn't all bad news, though. It’s just that the bad news (on volumes and revenues) mostly related to things the market feels might spell trouble for the company’s long-term competitive position, while the good news was mostly down to relatively mundane matters like cost control and the weaker Australian dollar.

The bad news on volumes and revenues came on several fronts, but was focused on the US, where shipping commenced following the second round of CMS (Centers for Medicare and Medicaid Services) competitive bidding.

We wrote about this in ResMed: Breath deeply and Buy on 29 Apr 13 (Buy – $4.56), but while management said then that it expected competitive bidding to push overall annual price reductions to the top of the 3–5% range it normally expected, it said on Friday that it was now seeing falls of 5–7%. That takes it the wrong side of the 5% cost savings the company targets annually.

There was also a disruption to volumes as distributors adjusted their systems to accommodate competitive bidding. ResMed said this adjustment probably had months to run, rather than weeks or quarters.

Despite all this, the company held its own in flow generator sales in the Americas, which grew 5% to $89m, compared to its estimate of 4-6% growth for the overall industry. But the performance in masks was very disappointing, with sales up just 3% to $113m, compared to the 8-10% growth it estimates for the overall industry.

Losing share in masks

On top of the pressures from competitive bidding, mask sales suffered due to strong performances from competitor masks launched last year, while ResMed’s own latest masks launched only recently. This fits with what we heard from F&P Healthcare at its analyst day last month, which we wrote about in F&P Healthcare: Breathing Easy.

Although ResMed held its market share in full-face masks, thanks largely to the very successful launch of the Quattro Air late in the fourth quarter, it lost share in the nasal and pillows categories. However, the company said that its latest nasal offering, the Swift FX Nano, launched in September, had been well received, and that it expected this and other launches during the remainder of the year to ‘put it back on the front foot’ in these categories.

The proof of the pudding will be in the eating, but this highlights an important point: competing with the industry heavyweight isn’t just about coming up with a good range of products and sitting back to collect the cash. You actually have to keep coming up with better products and that’s a big ask for the likes of F&P Healthcare given that ResMed spends around three times as much on research and development.

Around the rest of the world, Asia Pacific was ‘lumpy’ with particular weakness in Japan, but Europe performed well.

Margin improvement

The good news was on margins. Gross margins rose from 61% to 64% mostly thanks to the weaker Australian dollar, but also helped by a continued shift towards the premium – and higher margin – automatic pressure machines. Operating margins rose from 24% to 27%, as general expenses rose only 3% and research and development expenses rose only 1%. Both were helped by currency effects, but particularly research and development, which is mostly conducted in Australia.

Overall, earnings per ASX-listed CDI rose 14% to 5.6 US cents, which doesn’t look too bad, but it was a ‘low-quality’ increase mostly stemming from cost control and currency effects, and it lagged the consensus forecast of about 5.8 US cents.

The company will pay a 2.5 US cent quarterly dividend per ASX-listed CDI (unfranked, ex date 13 Nov). If that’s kept up for the year, it would mean 10 US cents of dividends in total, for a yield of about 1.9%. In addition, the company spent US$21m buying back shares in the quarter, and expects to spend around US$110m for the year (at current prices).

Between them the dividends and the buy backs should amount to about US$250m, but free cash flow of US$340m (compared to last year’s US$325m) would see most of US$100m added to the US$534m net cash with which the company finished 2013 – equivalent to about 8% of the company’s market value.

Buying opportunity

Despite the disruption from competitive bidding in the US and a weak recent performance from masks, the longer-term case for ResMed remains intact. The company is the leading provider (with a market share of a little over 40%) in a market which adds massive value, yet remains relatively underdeveloped.

On top of the obvious benefits of a good night’s sleep, treating obstructive sleep apnea can help with a range of diseases, such as heart disease and diabetes, improving quality of life, slowing disease progression and reducing healthcare costs. There are also wider implications, with an estimated 28% of US truck drivers suffering from sleep apnea and sufferers estimated to have six times the risk of a crash (see page 16 of ResMed’s 2013 half-year presentation).

Recent moves towards home sleep testing (HST) is increasing the diagnosis of new patients as well as the penetration of higher margin automatic pressure machines (HST produces a less accurate diagnosis, so automatic machines are required).

The company has also recently released a new machine to help with chronic obstructive pulmonary disease (which is helping it increase its market share in respiratory care) and it is trialing a machine to help with the treatment of heart failure.

Short-term disruptions have provided good buying opportunities for ResMed in the past and we expect this will prove to be another of these occasions. The stock is barely changed since ResMed: Result 2013 from 2 Aug 13 (Buy – $5.46). BUY.

Note: Our Income and Growth portfolios own shares in ResMed.