By Jake King
Shares of ResMed Inc. (RMD) have finally found their top, peaking at $48.37 in late January before dropping to the $43 level. But the downslide isn't over yet. RMD had a great run in the back half of 2012, with a cult, "do no wrong" following that pushed shares on a meteoric ride with little heed for valuation, given the company's strong earnings growth. Now, with a P/E ratio that's way overdone, forward growth a key question due to looming and worse-than-expected Medicare reimbursement cuts, competitive pressures, and tough earnings comparisons to boot, PropThink's prior short thesis is ready to play out. We were too early on this call last year, but with the same pressures we saw getting closer and becoming more apparent to investors, we believe now is the time to take advantage of the potential downside in RMD. In fact, company management sees the same trouble, with a massive amount of stock selling by the people that know the company best. Since November, company insiders have exercised considerable numbers of options and sold approximately $30M worth of RMD stock. RMD's growth has been strong, but we believe the music has stopped, and everyone will be scrambling for a seat.
In addition to the forward pressures, there have also been questions about how the company has achieved its stellar earnings results, with the potential that the distribution channel is already full of RMD product. Even bullish Wall St. analysts have been lowering their earnings expectations for this company - growth may not be there to support RMD's lofty valuation. In this article we focus on the latest proposed Medicare cuts, which were much worse than expected, and a competitor, 3B Products, which is gaining traction with a similar, but lower-priced product line. RMD's future growth is highly questionable, and with the stock trading at over 19x 2013 EPS compared to the large cap device companies at 13x, and mid-cap device companies at 15x, RMD's P/E multiple could compress by 4 to 6 points. An anticipated $2.23 in EPS this year implies that RMD could fall by $10.00 to $14.00 per share. We believe that investors will follow RMD management's stock selling activities and expect the stock to continue to fall further after peaking in late January.
Worse-Than-Expected Reimbursement Cuts Put RMD's Growth At Risk. ResMed is a major manufacturer of airflow generator equipment based on CPAP (continuous positive airway pressure) therapy. This equipment (air flow generators and masks) is designed to deliver pressurized air through a nasal mask to prevent collapse of the upper airway during sleep for patients with sleep apnea. ResMed's customers, distributors of durable medical equipment (DMEs) and home health equipment (HMEs), are anticipating deep cuts to reimbursement. Recently, the Centers for Medicare and Medicaid Services ((CMS)) proposed cuts to reimbursement for CPAP therapy by a whopping 47%, way worse than analysts and investors were expecting. The new lower pricing will become effective in July, with a full rollout to all major U.S. regions by 2016.
The reason for the initial lower expectations was that the first round of cuts was in the 32% range. In fact, a prior survey by VGM Group, a buying group for DMEs, indicated that Round 2 of the CMS "competitive bidding" cuts would feature a CPAP product discount of ~28%. The 47% discount was a major shock, and a big negative for CPAP equipment and service providers. We expect this discount to impact CPAP equipment manufacturers as well, especially RMD, which has the leading share in the market. The competitive bidding cuts will directly affect the DMEs and HMEs and in turn, these home health equipment and service providers will look to manufactures for discounts or will use alternative suppliers to lower their costs and maintain profit margins. For example, Lincare Holdings (LNCR), the largest DME distributor, has announced supply chain initiatives including vendor consolidation and lower pricing to offset reimbursement cuts - a strategy that other DMEs are likely to follow. This shows that the DMEs and HMEs will likely look for concessions from their suppliers (i.e. ResMed) to offset losses in revenues.
Government spending cuts can severely impact a company's financial performance. Case in point, nursing homes such as Skilled Healthcare (NASDAQ:SKH) and Sun Healthcare (NASDAQ:SUNH) tumbled more than 60% when CMS cut reimbursement by 11.1% a year and a half ago. Lincare Holdings, a provider of oxygen, respiratory and other services to patients at home, reported a 35% decline in EPS from 2008 through 2009 due to a 15% reduction in reimbursement caused by Medicare's 36-month oxygen cap, as well as a 9.5% DME cut, both of which took place in early 2009.
In addition to the CPAP reimbursement cuts, another rule proposed by CMS, which went into effect in early August, is putting pressure on RMD's fastest-growing product - disposable masks sold with CPAP equipment. In the past, over half of RMD's top-line growth came from CPAP masks and other accessories. We expect this trend to continue to weigh on the company's ability to generate growth, especially as less expensive competition gains traction. While analysts are already cutting their numbers for RMD, further revisions to the downside are likely, with the potential for ratings downgrades on the stock.
Competition Could Provide A Solution For DMEs and HMEs To Maintain Profits. There are a number of CPAP equipment manufacturers, and while RMD's products are typically preferred, the size of the CMS reimbursement cuts may force DME providers to look for alternatives to maintain their profitability. Our industry sources tell us that one manufacturer, 3B Products LLC, is gaining traction in the segment, with LNCR increasing its distribution of this product line. The links below highlight 3B's products, which are competitive to RMD's leading CPAP line, with cost savings of between 45%-55%.
Swift FX Nasal Pillow CPAP Mask (ResMed) - $127.00
S9 AutoSet w/H5i Humidifier (ResMed) - $1079.00
Outright switching by the DMEs and HMEs to products like 3B's RESmart device and Willow Nasal Pillow Mask could cause RMD to lose significant market share or allow the DMEs and HMEs to negotiate better pricing from the company. Either way, we believe that RMD is going to have to fight an uphill battle, hence, the company's significant sales and earnings growth story is likely coming to an end.
Disclosure: I am short RMD.
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