The ResMed result we've been waiting for

They say the secret to happiness is to have low expectations. With that as a backdrop, this was the best ResMed financial result we've seen in a while.  

Revenue grew 14% excluding the effect of currency fluctuations to US$514m for the three months to March. It was, however, meaningfully boosted by last year's US$800m acquisition of software maker Brightree. Excluding acquisitions, revenue was up a more modest 6%.

Underlying sales from North America increased 5% compared to the prior year, driven by strong demand for the company's new masks and continuous positive airway pressure (CPAP) machines. After throwing Brightree into the mix, North American revenue was up 18%.

Brightree's software covers things such as billing, patient resupply and business analytics. Management said it's making progress regarding the integration of these features into ResMed's own cloud-based software platform called ‘Air Solutions', which organises monitoring and treatment, then wirelessly feeds patient data back to the healthcare provider.

The ultimate goal is to integrate the well-liked Air Solutions platform with the work flow functionality of Brightree's software to improve efficiency for healthcare providers, though it's still early days.  

Combined revenue from ResMed's other markets – Europe, Middle East, Africa, and Asia Pacific – increased an unusually hearty 9% in constant currency terms, well above the 3% growth seen last year. The result was fuelled by strong demand for the company's new AirFit 20 range of masks and accessories.

Finally, a new direction

The standout element of the result was an improvement in the company's gross margin from 57.3% to 58.3%. The difference may be small, but the change in direction is significant. Margins have been falling for a good three or four years now as costs outpace revenue growth.

Management said the margin improvement was due to cost cutting in manufacturing and procurement, which is great to see. Unfortunately, it also said average selling prices continue to decline.

The average selling price of masks has decreased by more than 10% over the past few years due to strong competition from the likes of Fisher & Paykel Healthcare and US-based Philips Respironics.

The respiratory care industry is becoming increasingly price competitive as customers receive less favourable government subsidies – especially in the US, where ResMed earns 65% of its revenue. This being the case, differentiating your product from the competition is paramount, which was a big motive for ResMed's acquisition of Brightree.

Management said the gross margin also benefited from the acquisition of Brightree, which is a higher margin business. Management didn't separate the goats from the sheep, so it's hard to tell how much of the advance was from ResMed's efforts, though we'll have a better idea at the full-year result. For now, we'll take whatever margin improvement we can get.

Anchored profits

Sadly, the revenue growth and margin improvement didn't translate into profit growth, with net profit down 3% to US$88m. Sales and administrative expenses rose 16% in constant currency terms, which speaks to the increasing difficulty – and cost – of finding new customers. Even after removing one-off restructuring expenses, underlying earnings per share were up a meagre 3%.

Some of the higher costs were due to a 21% increase in research spending. Given lower selling prices and a strong product line-up at competitors, this is one expense we're happy to see outpace revenue (at least for a time). As a proportion of sales, ResMed still trails F&P Healthcare in research spending, 7% to 10%.

Several new products are on the horizon and the company launched the new AirMini earlier this week, which is the smallest CPAP machine now available. This should make it a popular choice for customers who travel a lot or who otherwise don't want the inconvenience of a bulky CPAP device. It will be interesting to see how sales go over the next few months and whether ResMed is able to increase its market share.

The stock trades on a forward price-earnings ratio of 30 given consensus estimates for 2017 earnings. Even though this result had several bright spots, price competition continues to concern us. Costs are also growing faster than revenue, which is restricting profit growth. A price-earnings ratio of 30 could make sense if ResMed was growing as fast as Cochlear or CSL, but today's valuation is baking in a lot of hope that's yet to materialise.

We're raising our price guide slightly to give more wiggle room should things continue to improve, but ResMed is closer to a downgrade than an upgrade. If the company 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.