Innovator ResMed to reward patient investors

Financial Journalist
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The great challenge for value investors is to buy exceptional, undervalued companies. Respiratory medical device manufacturer ResMed Inc fits the first category, but at current prices is trading near fair value. However, on a long-term view, ResMed is a buying opportunity.

A question of timing

The question is not whether to buy ResMed (RMD), but when. Portfolio investors, such as self managed superannuation funds, could justify buying ResMed now, provided they can withstand potential share-price volatility over the next two quarters, and hold the stock for several years.

ResMed (RMD)

 

Active investors could wait for better value. The Australian share market is ripe for a mid-year pullback, or even a correction, as short-term pressures on equities intensify. I am bullish on the sharemarket in the medium term and expect a fourth-quarter rally this year.

But a quarter or two of higher volatility and share-price weakness would not surprise. In this scenario, stocks such as ResMed, trading on relatively high Price Earnings (PE) ratios, could be candidates for profit taking, as more fund managers lift portfolio cash weightings in the next few months in anticipation of adding more stocks back at lower prices.

Yes, trying to second-guess market movements is a mug’s game. It is far better to focus on company quality and valuations than bet on short-term market movements. Nevertheless, active investors should consider accumulating ResMed over the next few months, ideally at lower prices, rather than buying in one go. There is no need to rush in for the company in the next few months.

The outlook

Patient investors will be rewarded with ResMed. Although it does not receive the plaudits of Cochlear or CSL, it is one of the market’s more exceptional companies and a great Australian innovation success. It has a superb position in a superb growth market to treat sleep-disordered breathing problems.

ResMed specialises in making and selling products for the diagnosis and treatment of obstructed sleep apnea, a potentially life-threatening condition that involves repeated episodes of airway obstruction during sleep due to the relaxation of tongue and airway muscles.

Research shows patients with obstructive sleep apnea have a seven-fold higher risk of death and heart disease. Other findings have shown links between this condition and problems such as mood disorders.

The US National Heart, Lung and Blood Institute estimates more than 12 million people in the US alone have sleep apnea. Millions more are potentially undiagnosed, and this trend will surely strengthen as the rate of obesity worldwide increases. More than half of US sufferers are overweight.

ResMed is targeting a growth industry. As awareness of sleep apnea increases, and as more chemists stock continuous pressure airway (CPAP) machines and masks, sales will rise. It’s just the type of industry that suits investors with long investment timeframes.

ResMed has several hallmarks of exceptional companies: high gross margins (more than 60%), strong return on equity (19% in FY13, up from 13% in FY11), low debt, excellent cash flow, high cash reserves (more than $1 billion in the current quarter), and a strong position in the large US market. Surplus cash has helped it buy back shares.

ResMed’s operating performance is improving. Its recently reported third-quarter results were slightly better than expected, with revenue increasing 4% to US$397.8 million on the same period last year. The result was generally well-received by analysts and led some to upgrade their valuations.

The numbers

Two aspects of the result stood out. First, ResMed’s mask sales in the US rose by 4% over the second quarter, due to solid uptake of its much-anticipated AirFit P10 nasal pillow. It had lost market share in the nasal devices market, off a high base, and the launch of the Swift FX Nano direct nasal mask last year disappointed. Its Quattro Air full-face mask is still doing well.

AirFit’s early success is an important development. History shows that well-received product launches for ResMed boost earnings, as large numbers of current users upgrade to new masks. Nasal masks have good potential because they are more comfortable than full-face masks that connect to the flow generator that pumps air to the patient during the night.

Also, there is a high rate of non-compliance with CPAP machines. Some sufferers find having air blown into the mouth or nose during the night is intolerable. More people are using dental devices that treat obstructive sleep apnea, and reportedly offer higher comfort, although this is a small part of the market. A more comfortable, quieter nasal mask from ResMed has good potential.

The second aspect of the quarterly report was signs that the company is overcoming pricing disruption from the roll-out of the Medicare competitive bidding (CB2) initiative in the United States. The change means significantly lower reimbursement rates for independent distributors of ResMed products in the US. It led to fears that the company’s margins would be eroded.

However, such sales account for about 10% of ResMed’s sales, and the market fears that led to falls in its share price between October 2013 and April were overdone, judging by its largest quarterly result – which was yet another record. Greater competition from Fisher & Paykel and Respironics in the sleep apnea market is a bigger long-term threat.

ResMed has a strong product pipeline in the next 18 months. A new S10 flow generator this year, more market share gains from AirFit, and easing concerns about US health funding reforms should support the share price.

Key to its success is the ability to retain high profit margins, which are currently ahead of its competitors. Stronger volume growth and high margins have the potential to lift ResMed’s earnings growth and its intrinsic valuation, with the share price to follow.

Conclusion

The market, of course, is aware of these strengths. ResMed has a three-year average annualised total shareholder return (including dividends) of 23% to 21 May 2014. Over five years, the return is almost 20% and over 10 years, Resmed has delivered an average 12% annual return.

Morningstar has a fair value of $6 a share for ResMed, Lincoln’s valuation is $5.33 and FN Arena has a target price of $6.03. At $5.45, ResMed looks marginally undervalued against broking forecasts. Consensus estimates on FN Arena have ResMed trading at 17.9 times FY15 earnings, which is reasonable for a high-quality technology company with a strong position in a multi-billion-dollar global market.

The stock provides sufficient value for long-term investors to buy now. And potentially better value for active investors, who can watch and wait, and possibly accumulate ResMed at lower prices in the next few months, as sharemarket volatility in the second and third quarter increases.

Tony Featherstone is a former managing editor of BRW and Shares magazines.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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