ResMed v Cochlear a two horse race
Recommendation
Speech is integral to being human. But to learn and to understand speech, one must first hear it. The stories of profoundly deaf people hearing for the very first time after receiving a cochlear implant are profoundly moving and a testament to humanity’s ingenuity.
Getting a decent night’s sleep can be life-changing, too. For the mostly middle-aged sufferers of obstructive sleep apnoea (OSA), strapping on a mask attached to a CPAP (continuous positive airway pressure) machine can literally add years to their lives. It’s less a fountain of youth than an appliance of longevity.
For further information on these companies and the conditions they treat (such as OSA), head to the ‘Editor’s Picks’ section of the ResMed and Cochlear home pages. |
Cochlear assists the profoundly deaf, ResMed the poor sleepers. Having developed medical devices that change lives the world over, both truly deserve to be called ‘international success stories’.
But while Intelligent Investor has recommended Cochlear many times—including an outright Buy below $20.00 in 2004—ResMed has yet to pass all tests (see Keep sleeping on ResMed from 16 Aug 07 (No View – $2.40)).
Key Points
- Resmed and Cochlear each have desirable business characteristics
- Cochlear pips Resmed in the quality stakes
- Hold recommendations on both
Since dedicating more time to analysing ResMed, those initial concerns have eased somewhat. In this review, we’ll use a series of tables to compare ResMed with Cochlear. And we’ll answer the question: Could ResMed displace Cochlear as the ‘gold standard’ of medical device companies?
Let’s start with the key information in Table 1.
ResMed’s market is much larger than that of Cochlear’s with the company estimating that up to 20% of the US population has OSA. Both companies are inclined to talk up market size, however, so the eligible populations are probably much smaller. Either way, there are a large number of people yet to be treated. Neither company is likely to run out of patients.
ResMed | Cochlear | |
---|---|---|
Therapy for | Obstructive sleep apnoea | Moderate to profound hearing loss |
Therapy | CPAP machine and mask | Cochlear implant |
Estimate of population affected (%) | 7-20 | 0.3-3.0 |
Eligible population already treated (%) | <10% | <10% |
Revenue from accessories (%) | 44 | <5 |
Cost of therapy ($A) | c. $1,400-$2,000 (CPAP machine) | c. $25,000 (per ear) |
c. $250-$300 (mask) | ||
Who pays (Australia)? ('reimbursement')^ | Patient# | Private health fund/Medicare |
Market shares (est.) | Resmed (40%) | Cochlear (70%) |
Philips Healthcare (40%) | Advanced Bionics (Sonova) (20%) | |
Fisher & Paykel Healthcare (10%) | Med-El (10%) | |
Others (10%) | ||
Management ownership (%) | c. 1% | 1.3% |
^varies by country #(some private health funds provide limited reimbursement) |
ResMed’s business model is particularly attractive. Like shaving company Gillette, it has a ‘razor and blade’ model, selling long-lived CPAP machines (costing around $2,000) but generating 44% of revenue from replaceable accessories such as masks (costing around $300).
ResMed is respected for the comfort of these accessories, making them a valuable source of annuity income. By contrast, Cochlear makes the vast majority of its revenue from the implant itself, which costs $25,000.
In many developed countries like Australia and the US, the cost of cochlear implants is usually reimbursed by health insurance or Medicare (Medicaid in the US). In Australia, however, Medicare doesn’t cover CPAP machines or masks, while reimbursement from private health funds is limited (US health funds are more generous).
More deserving?
This suggests that in Australia at least, medical authorities regard Cochlear implants as more ‘deserving’ than CPAP machines. Perhaps this is because the deaf population is small and readily identifiable, or it‘s maybe that many sufferers of OSA could reduce their condition by making lifestyle changes.
In ResMed’s own words, OSA ‘is predominant among middle-aged men and those who are obese, smoke, consume alcohol in excess and use muscle-relaxing or pain-killing drugs’. Given limited healthcare funding, these are the decisions medical authorities must make.
Looming changes to the way ResMed’s products are sold might matter, too. US health insurance funds have been pushing for at-home diagnosis of OSA (see Waking up to ResMed from 28 Sep 09 (No View – $2.62)). While this reduces bottlenecks at sleep clinics—the traditional method for diagnosis—it could also change the way patients choose products.
As ResMed sits at the premium-priced end of the product spectrum, it has a lot to lose from a price war. By contrast, Cochlear has much greater control over its distribution and a stronger market position.
Table 2 contains selected financial data and ratios. Over the past five years, Resmed’s sales and earnings growth has significantly exceeded that of Cochlear, reflecting a rising awareness of OSA and the larger size of the market. ResMed’s potential future growth is arguably higher than it is for Cochlear but so is the risk of heightened competition.
2011 numbers except where indicated | ResMed | Cochlear |
---|---|---|
Sales growth 2007-2011 (% pa) | 11.7% | 6.1% |
EPS growth 2007-2011 (% pa) | 27.3% | 11.9% |
Net debt (cash)-to-equity (%) | (36.7%) | (1.9%) |
R&D (% of sales) | 7.4% | 15.0% |
Gross margin (%) | 59.6% | 68.5% |
EBIT margin (%) | 21.5% | 33.1% |
Return on equity (%) | 13.1% | 35.8% |
Return on assets (%) | 12.9% | 32.4% |
With both companies enjoying net cash on the balance sheet, debt isn’t an issue. As for free cash flow, ResMed’s has surged since the concerns outlined in Keep sleeping on ResMed. Indeed, the company is producing so much that $500m of net cash has accumulated on the balance sheet despite a share buyback and acquisition program.
What of the vital area of innovation? ResMed spends 7% of sales on research and development but Cochlear invests more than twice that. Both sport impressive margins, although Cochlear’s gross margins and earnings before interest and tax (EBIT) margins are around 10 percentage points higher and have climbed over the past 10 years.
ResMed’s margins, by contrast, have fallen over the same period, an indication of greater industry competition. Management admits that prices tend to decline by a few per cent each year, so volume growth is necessary to achieve sales growth.
While ResMed’s returns on equity and assets are respectable, they’re not a patch on Cochlear’s. But nor are they as pedestrian as they appear; return ratios are currently depressed by the company’s significant cash holdings, although they have risen in recent years.
ResMed | Cochlear | |
---|---|---|
EV/Sales (x) | 3.5 | 4.5 |
EV/EBIT (x) | 16.5 | 13.7 |
PER (x) | 22.2 | 18.3 |
Free cash flow yield (%)* | 3.4% | 4.6% |
Dividend yield (%) | 0.0% | 4.0% |
* Average 2010 and 2011 |
Table 3 offers some valuation statistics. On first blush, ResMed looks more expensive than Cochlear, with a slightly higher enterprise value (EV) to EBIT multiple and PER. These are lower multiples than each stock has traded on historically, reflecting lower growth expectations. Both companies will achieve minimal earnings growth in 2012. With Cochlear’s earnings currently inflated by profits from its foreign currency hedging program (see Shining a light on Cochlear from 15 Aug 11 (Hold – $69.10)), the company’s ‘real’ PER is somewhat higher.
Earnings power
The free cash flow yield is probably a better indication of earnings power and, here, Cochlear comes out on top. Averaging the past two years figures, Cochlear’s free cash flow yield of 4.6% is superior to ResMed’s 3.4%. But whereas Cochlear pays out most of that free cash flow as dividends, ResMed doesn’t. No wonder cash keeps accumulating on its balance sheet.
Cochlear, with a dominant market position and superior margins and return on equity, remains the Rolls Royce of the Australian medical device industry. Notwithstanding last year’s recall, this is a business we’d love to own at the right price.
Closer to $50.00 a share, we expect to upgrade Cochlear to Long Term Buy but for now, with the share price down 7% since All ears at Cochlear’s results meeting from 9 Feb 12 (Hold – $62.48), the stock remains a HOLD.
Take Part Profits | Above $4.00 |
Long Term Buy | Up to $2.50 |
Buy | Below $2.00 |
ResMed’s competitive position is slightly weaker but the business still has many attractive qualities. Growth potential looks significant, although the push for at-home diagnosis is potentially a poisoned chalice. And the company’s strong position in masks is appealing as it reinforces the brand in consumers’ minds and provides it with a recurring revenue stream.
But with no dividends and ongoing share sales by company founder Peter Farrell, we’d prefer a greater margin of safety before recommending a purchase. Closer to $2.50 we’ll consider an upgrade but for now we’re commencing coverage with HOLD.
Note: The model Growth portfolio owns shares in Cochlear.