Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

ResMed, Inc. (NYSE:RMD)

F2Q09 (Qtr End 12/31/08) Earnings Call Transcript

February 5, 2009 4:30 pm ET

Executives

Kieran T. Gallahue – President and CEO

Brett Sandercock – CFO

Analysts

David Clair – Piper Jaffray

Peter Bye – Jefferies & Company

Andrew Goodsall – UBS

Joshua Zable – Natixis

Alex Smith – JPMorgan

Jim [ph] – Canaccord Adams

Ben Andrew – William Blair

Michael Matson – Wachovia Capital Markets

Dan Herron [ph] – UBS

David Stanton – ABN AMRO

Helen Cameron – Citigroup

Matthew Prior – Merrill Lynch

Todd Harrison [ph] – Credit Suisse

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 ResMed Incorporated earnings conference call. My name is Eric; I’ll be your audio coordinator for today. Now at this time, all participants are on a listen-only mode. We will facilitate the question-and-answer session at the end of the presentation.

(Operator instructions) Today, the company has asked me to address certain matters. First, ResMed does not authorize the recording of any portion of the conference call for any purpose.

Second, during the conference call, ResMed may make forward-looking statements such as the projections of future revenue or earnings, new product development, or new markets for the company's products. These statements are made under the Safe Harbor’s provision for Private Securities Litigation Reform Act of 1995.

Risks and uncertainties exist that could cause actual results to materially differ from the forward-looking statements. These factors are discussed in ResMed's SEC filings, such as Forms 10-Q and 10-K, which maybe accessed through the company's web site, at www.resmed.com.

With that said, I would like to turn the call over to Kieran T. Gallahue, ResMed's President and CEO. Mr. Gallahue, please go ahead, sir.

Kieran T. Gallahue

Thank you, Eric. Good morning and welcome to ResMed’s second quarter earnings call. As with our previous calls, I’m going to begin the call with some more remarks. Then I’ll turn it over to Brett Sandercock, our Chief Financial Officer, to go through the numbers in more detail and then we’ll take your questions.

Well, we had another very solid quarter, one that once again demonstrated the power of having a well-balanced geographically diversified company. We are pleased to report that global revenue for the second quarter of 2009 grew 10% or up 16% on a constant currency basis. Revenue growth in the Americas accelerated by 23%, up sequentially from 16% in Q1. Rest of world revenue declined by 3% but in constant currency terms grew 8%. As expected, currency had a significant effect on ROW revenue.

GAAP EPS increased 29% to $0.44. Excluding amortization of acquired intangibles, EPS was $0.01 better at $0.45. We also experienced balanced growth across product categories with global flow generator sales up 9% or 15% in constant currency, and mask segment growing at 12% during the quarter, which was 16% increase on a constant currency basis. We saw significant growth in all product segments of flow generators, but especially with our high-end flow generators, the S8 II Autoset and Elite II that we have launched in Q4, as well as our midrange S8 Escape II. Both revenue and unit volume increased across the flow generator product line.

Sales of Americas flow generators were up 25% in Q2, a healthy increase from 14% growth in Q1. Our new Easy-Breathe technology is setting a new standard in the industry and is helping to differentiate ResMed from our competitors with improved noise levels, comfort and performance. It’s notable to mention that the fastest growing segment of the US flow generator business in percentage terms has been our Autoset product line and that trend continues. Our newly introduced bi-level devices in the smaller S8 box continued to gain momentum in Q2. This brings the Easy-Breathe Technology into our bi-level product line and we’re excited about the potential upside with its second quarter sales now recorded.

The VPAP product line continues to exceed our expectations with significant growth in the quarter with the launch of the VPAP S, and we continue to gain market share in this important high-margin flow generator market segment. As I speak today, our entire new line of VPAP devices are now available in all major global markets. And over the next few quarters, we will continue to execute on our strategy to differentiate our innovative technology with these new market-leading products. In addition, as a result of changing product mix in this category, our gross margins are improving.

Once again, we posted double-digit growth in the mask segment globally during the quarter. New product introductions included the Activa LT and Swift LT for Her. These redesigned LT masks are smaller, wider and more streamlined versions of their predecessors. We expect the Swift LT for Her product will provide a comfortable and quiet solution for our female patients, as this is the first and only gender-specific product on the market. This is an important market for us. According to some of our Sleep Lab partners, women now represent 30% to 50% of their newly diagnosed patients.

And the Activa LT is less intrusive [ph] masks which gives patients superior performance and potentially fits 90% of all patients. The simplicity of this provides an opportunity for our HME providers to accommodate a wider number of patients with a single mask. So with these new masks in the global marketplace in Q3, we remain focus on growing market share with high-margin industry leading products.

Looking forward over the next 18 months, our pipeline of products is the most robust it has been in the company’s history and we plan to launch a series of new masks and flow generators over that time period. In addition, towards the end of fiscal 2009, we plan to introduce the ApneaLink Plus, our type III home diagnostic device that will meet existing reimbursement and physician requirements.

Throughout calendar 2009, we’ll be watching home testing carefully and expect home testing to be piloted in various forms. We are working closely with our sleep position partners to make home testing a reality that can improve patient access to appropriate therapy.

Encouragingly, gross margin improved in Q2, benefiting from a favorable product mix driven by high-end flow generators and masks as well as our margin improvement plan gaining traction. We’re confident that we will continue to improve gross margin in fiscal year 2009 as we further penetrate markets with out new products and we continue to leverage cost efficiencies across our global organization.

Once again, we had strong performance in operating cash flow, which came in at $56.5 million demonstrating our commitment to strong operating performance and a commitment to working capital control. Our balance sheet remains extremely strong with cash and cash equivalent balance at the end of Q2 of over $320 million.

Finally, I’ll touch on the current economic environment as I know it is a question in everybody’s mind today. As you can see from our Q2 results, we have not felt the level of impact experienced by some other sectors of the healthcare community or for that matter, the general business community. We think this is because of the continued patient and medical community awareness and the central role that quality of sleep and sleep disorder breathing plays in the overall health in the continuing peer reviewed literature published supporting CPAP as the gold standard treatment for sleep disorder breathing. That being said, we recognize the need to continually monitor the market and the economy, and we plan to do so.

Finally on the market development front, we have just completed a calendar year that bodes well for the future of this market. There continues to be validation of the critical role that sleep disorder breathing plays in the very serious co-morbidities such as cardiovascular disease and diabetes. As a reminder, the latest European Society of Cardiology guidelines refers to the importance of identifying and treating sleep disorder breathing in heart failure patients.

Also, the International Diabetes Federation consensus statement on sleep apnea published last June concluded that type II diabetic should be evaluated to determine if SDB is present and they went on to note that CPAP treatment is the gold standard therapy. These influential global bodies confirmed what we have been communicating on the critical need to identify and treat sleep disorder breathing in patients suffering from two of the most chronic, fast-growing and most costly diseases in the world. ResMed remains well positioned to serve this market as it expands.

All right, now over to Brett to provide some additional detail on the P&L and then we’ll come back and take your questions. Brett?

Brett Sandercock

Thanks, Kieran. I’ll briefly run through our December quarter results in a little more detail. So as Kieran mentioned, revenue for the December quarter was $223 million, an increase of 10% over the prior year. And as expected, unfavorable currency movements reduced our Q2 revenues by approximately $11.1 million. In constant currency terms, the revenue increased by 16% over the prior year quarter.

Income from operations for the quarter was $43.3 million, an increase of 18% over the prior year quarter, and net income for the quarter was $33.9 million, an increase of 26% over the prior year. Earnings per share for the quarter was $0.44, an increase of 29% over the prior year quarter.

Excluding amortization of acquired intangibles, our earnings per share for the quarter was $0.45. Gross margin for the quarter was 58.8%, up sequentially from Q1 of FY09 reflecting favorable product mix, manufacturing improvements, and foreign currency movements. The product mix impact was largely attributable to the acceleration of sales growth, both in the bi-level range, and also our Autoset devices particularly in the domestic market.

Manufacturing initiatives, including our continuous improvement program, are also positively impacting margins. Additionally, towards the end of the quarter, we saw the initial benefits from the depreciation of the Australian dollar. This currency impact together with our ongoing margin improvement initiatives in areas such as supply chain, manufacturing and product development, should see further improvement in our gross margin in the second half of fiscal 2009.

SG&A expenses for the quarter came in at $70.1 million, an increase of 4% over the prior year quarter. In constant currency terms, SG&A expenses increased by 14% over the prior year quarter. SG&A as a percentage of revenue, improved to 31% compared to the year ago figure of 33%. The modest growth in headline [ph] SG&A expenses reflects the full impact of the depreciation of international currencies against the US dollar.

R&D expenses for the quarter were $14.9 million, consistent with the prior year quarter. In constant currency terms, R&D expenses increased by 27% over the prior quarter. R&D expenses as a percentage of revenue is 7% and again that was consistent with the prior year. Looking forward and subject to currency movements, we expect R&D expenses as a percentage of revenue to be in the 6% to 7% range for the second half of 2009. We will continue to invest in product innovation throughout the economic cycle.

Amortization of acquired intangibles was $1.7 million for the quarter and stock-based compensation expense for the quarter was $6.8 million. During the quarter, we also donated $1 million to the ResMed Foundation.

Turning now to revenues in more detail, overall America sales were $123.1 million, an increase of 23% over the prior year. This was driven by strong growth in both flow generators and masks with an extra [ph] contribution from our new bi-level range which is in the S8 box, and also continued strong sales of Autoset devices.

So the outside of the Americas totaled $99.9 million, a decrease of 3% over the prior year and as expected outside of the Americas were impacted by currency movements, in particular the depreciation of the Euro against the US dollar. In constant currency terms, sales outside the Americas increased by 8% over the prior year quarter. Sales outside the Americas were also impacted this quarter by lower sales of our VS ventilation range.

Breaking out revenues between product segments, in the Americas, flow generator sales increased by 25% over the prior year, while masks and other increased by 21%. The revenues outside the Americas, flow generator sales decreased by 3% over the prior year while masks and other decreased by 1%. However, in constant currency terms, flow generators outside the Americas increased by 8%, and while masks and other increased by 10%.

And looking at it on a group basis, flow generator sales increased by 9% over the prior year quarter, and masks and other increased by 12%. In constant currency terms, we saw a quite balanced growth with flow generator sales increasing by 15% and masks and other increasing by 16%.

Cash flow from operations was a robust $66.5 million for the quarter, reflecting strong underlying earnings, improved working capital and lower corporate tax payments.

Capital expenditure for the quarter was $27.4 million including $19.5 million in building construction costs, such as with the construction of our new headquarters in San Diego. We expect to incur further construction and fit-out [ph] cost of approximately $31 million over the balance of fiscal year 2009 with the building completion expected towards the end of the fiscal year. Depreciation and amortizations for the quarter totaled $11.7 million.

We continue to buy back shares as part of our capital management program. During the quarter, we repurchased approximately 56,000 shares at a consideration of $2 million, as part of our ongoing buyback program. As of today, we have repurchased approximately 5.6 million shares out of a total approved buyback of 8 million.

ResMed ended second quarter fiscal year 2009 in excellent financial shape. Our balance sheet remains very strong and is conservatively geared. At December 31, total assets stood at $1.3 billion and net equity was $1 billion. Cash and cash equivalents net of external debt totaled $168 million.

I would now like to make some comments in relation to currency movements and their expected impact on FY09 second half results, assuming current exchange rates. Firstly, we will continue to experience year-on-year currency headwinds in relation to group revenue. In Q3, we estimate a currency headwind of between $15 million and $20 million, while in Q4 it is estimated to be in the range of $20 million to $25 million.

Conversely, our operating expenses will continue to benefit from the depreciation of international currencies relative to the US dollar. This benefit is already reflected in our Q2 result and therefore it provides an indicative base for our operating expense run rate over the next few quarters. Finally, from Q3 onwards, the full benefit of the Australian dollar depreciation should be reflected in our gross margin. There are clearly many factors that impact gross margin. However, on balance, we expect gross margin to improve relative to our second quarter gross margin.

In summary, we expect currency movements to have a positive impact on our net income in the second half of FY09 and we expect net income to grow faster than our constant currency revenue growth.

I would now like to hand the call back to Kieran.

Kieran T. Gallahue

Great. Well, thank you, Brett, and certainly, we’re quite pleased with the performance of the company and the team during this last quarter. And with that, why don’t we turn it over for questions?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of David Clair with Piper Jaffray. Please proceed.

David Clair – Piper Jaffray

Hey, guys. Congratulations.

Kieran T. Gallahue

Thanks, Dave.

David Clair – Piper Jaffray

Just a quick question on gross margin in the quarter. What was mix versus currency, the impact there? Can you split that out for us?

Kieran T. Gallahue

I’ll turn it over to Brett in a second, but in that sense, we had a couple of different moving pieces that helped us improve margin. The basics are really what we laid out three quarters ago when we laid out what our margin improvement program was. We’ve seen some significant positive impact through the cost reduction exercise that we’ve gone through throughout the company; the high-valued products that we’ve been launching, both on the bi-levels and the masks, have been quite favorable; and obviously, the ForEx is beginning to have a positive impact there as well. The offsets to that were we haven’t quite annualized the ASP drops that came through in the fourth quarter of last year, so that was – even though the market has regulated itself in the pricing and we’ve been very pleased with the pricing stability in the market, we still need to go through that annualization process. That was sort of the offset. Brett, you have anything to add to that?

Brett Sandercock

Yes. I mean, that’s exactly right. If you look at the product mix and the FX, they have rationally equal positive impacts on the margin with smaller negative zone in terms of ASP declines, which are pretty normal, and small negative on geographic mix, obviously with the really strong growth in the Americas, (inaudible) to the Americas a little bit. But you take all those into account and you sort of end up with that 50 basis point improvement, but certainly product mix and FX were equally prominent in their contribution.

David Clair – Piper Jaffray

Okay, thanks. And then, I guess another question for you, Brett. You said in Q3, we should expect gross margin improvement versus the second quarter. I think everyone’s expecting that, but are you willing to give us some direction there? Are you looking for another 50 basis points sequential or how should we be thinking about that?

Brett Sandercock

I’m always cautious on margin because of the multiple impacts on the margin, but if I’m looking forward, I do think an expansion and what we’re looking at – of that order is certainly possible without virtually giving you an exact number. Certainly, I think it’s going to improve. If 50 basis points or more feasible? Yes, it certainly is.

Kieran T. Gallahue

We’ve been asked a couple of quarters ago about our ability by the end of the year to get back to 60% gross margins, and we said we believe that we could do that and we continue to believe that we can do that by year-end.

David Clair – Piper Jaffray

Okay, great. And just if I could sneak one last one in here, it looks like OUS constant currency growth was a little bit lower. I think it was a little bit lower last quarter too. I’m just wondering if there’s a certain geography or something, just some macro trend you could point out or give us a little bit of color there?

Kieran T. Gallahue

No. ROW is an aggregation of lots and lots of different countries and all have their different idiosyncrasies. The real impact this quarter was more on the ventilation line. We had introduced a product, a new ventilation product that Brett referred to, the VS III and we had introduced it during Q2, but we only began shipping it really this quarter. And so, you had some customers that were holding off on shipment of it, and so it’s little things like that that can add a couple of percentage points to the growth that got carved off; but we’re still pleased. Certainly, we had the currency headwind, but constant currency growth at 8% and a great balance of the Americas 23%.

David Clair – Piper Jaffray

All right, yes. Great quarter, guys. Thank you.

David Clair – Piper Jaffray

Thanks.

Operator

(Operator instructions) Your next question comes from the line of Peter Bye with Jefferies & Company. Please proceed.

Peter Bye – Jefferies & Company

Hey, guys. Thanks. On the US, the AutoSet and the VPAP, maybe you could give us a little more color on mix and the contribution versus units or anything you can give us there?

Kieran T. Gallahue

Yes. We don’t go into the great details but we can give you some color on it though. Look, they’re both doing extremely well, is the short answer to it. The S8 II on the PAP side, so when you look at both the AutoSet and the Elite as an example that we were introducing towards the end of last fiscal year, have continued to perform quite well. And obviously the impact of the bi-levels, we released most of them over the summer but continue to release product throughout Q2, so you saw that thing ramping up as we’re able to get to our various customers. They’re all doing extremely well. I can’t point to one and say it’s all that product or another product. The Easy-Breathe motor technology, particularly how quiet it is and how it improves performance, is being recognized by the industry. In the bi-level side, this is the first time that we’ve taken the bi-level in the big box and brought it down to the small box. It is a meaningful change to the customers and they’re recognizing that.

There’s also some other aspects of this. There’s been the data-capable products that we have, particularly those that are the data capability in the AutoSet, the Elite, and the bi-levels. With some of the changes going on at CNS, they’ve raised the awareness and the need to have data managed the way that we manage it. It’s more cost effective the way we do it. It protects the revenue the way that we do it and customers are recognizing that and rewarding us with their business.

Peter Bye – Jefferies & Company

I guess what we’re trying to get at is maybe how much runway there is left on that? Could you give us – maybe compared to internationally? I mean, do you have – is it the mix between the products? Is it halfway with where you are internationally? Is it 25%? Can you just give us maybe a sense that way or no?

Kieran T. Gallahue

No. I think the historical mix between – if you’re asking between the bi-levels and other flow generators, has remained relatively consistent. I would expect over the coming quarters that you’ll see a higher mix towards bi-levels simply because we made the greatest leap in bi-levels moving it from the S7 box down to the S8 small box and that easy. So, they’re both extremely well, but if I was going to say, I don’t know how many points that’s going to be a difference, but I could see bi-levels playing a bigger role as we move forward.

Peter Bye – Jefferies & Company

Okay, great. I guess that’s my question and follow-up, so I’ll get back in queue.

Kieran T. Gallahue

Okay. All right, thanks.

Operator

Your next question comes from the line of Andrew Goodsall with UBS. Please proceed.

Andrew Goodsall – UBS

All right. Thanks very much guys. Thanks for taking my question. I am just interested in what is sort of happening with the underlying market and I guess, in particular, if we'd sort of reflect on the numbers we can get out of what we saw with Respironics. It seems to me that you guys are probably taking some market share. If there’s any comment you can add on Apria?

Kieran T. Gallahue

I think the last couple of quarters, we’ve been talking about the Americas market has been growing around that 15%, maybe a point or so less on the revenue side, a little above on the volume side. The markets remained strong throughout the quarter and that would suggest that we are absolutely gaining share and I think we’re gaining share for multiple reasons. The team is executing extremely well. We have great new product flow that we were just describing a moment ago and we have seen some competitive wins both at mid-size accounts as well as some of the major accounts that you just referred to that helped us gain traction and share. So, there is not one reason that we’re seeing the performance improve; we are seeing it across the business.

Andrew Goodsall – UBS

And in terms of how much further that got to go, there’s still opportunity with those accounts?

Kieran T. Gallahue

Sure. Yes, we’ve got opportunities at both large accounts and the mid-size accounts, and we’ll continue to push that barrel.

Andrew Goodsall – UBS

Okay, terrific. Thank you very much.

Kieran T. Gallahue

You bet. Eric?

Operator

Next question comes from the line of Joshua Zable with Natixis. Please proceed.

Joshua Zable – Natixis

Hey, guys. Congratulations on a great quarter. Thanks for taking my questions and also special thank you to Matt Borer. I know you’re probably there listening. We really all appreciate your help and welcome to Conney [ph]. Just a couple of quick ones here. First, on the new products, I know, Kieran, you mentioned your pipeline is robust. I don’t want to jump ahead of ourselves and I know for competitive reasons, you’re not going to give too much, but it seems like your pipeline for newer products is coming quicker than historical, from what I remember. It seems like you already mentioned new generators. Is it just iterations or are you talking about new lines that you guys are already working on and we’re starting to see new products sort of come out quicker?

Kieran T. Gallahue

You’re right; we’re not going to give specifics on the timing. What we are referring to is over the next 18 months and we did refer to both masks and flow generators, and it will be a mix. There will be some platform changes and there will be platform extensions, so it is going to be all of the above. As far as the time to market, I would agree with you. I think we’ve seen some very good improvement for a number of different reasons. One, you’ve seen that we continue to invest very heavily in innovation. We are strong believers that there is an enormous amount of innovation to be brought to bear on this marketplace and that there’s patient meaningful and customer meaningful innovation that could be brought to bear in this marketplace. And so, we feel strongly that we’re going to need to keep the foot on the accelerator and spend behind that. We’re also spending smarter. We started these strategic business units about a year-and-a-half ago led by Don Darkin, Mick Farrell, and Stein Jacobsen. And they have done, I just think, a fantastic job of organizing the pipeline and energizing the team and focusing the team on execution and I think it is going to pay dividends as we move forward.

Joshua Zable – Natixis

Great. And then a follow-up totally separate. On SEM, I always ask this just related to the US or any new products, obviously you just launched the new one in Europe. I don’t know if that means we are coming to the US or anything like that. Can you give us an update?

Kieran T. Gallahue

Yes. So, we continue to make quite a bit of progress at the SEM organization or, as we call it now, the ResMed Paris organization. The leadership there has been outstanding. The team is motivated. We have done – and the team has done an excellent job of integrating not only the Paris site but other parts of the organization in order to drive forward product improvement and product development. The products that we’re introducing now remain focused predominantly on Europe but also some of the Asian marketplaces. We continue to believe that the entry into the Americas market is out about two years or so.

Joshua Zable – Natixis

Great. Thanks very much guys. Congratulations.

Kieran T. Gallahue

Thank you.

Operator

And your next question comes from the line of Alex Smith with JPMorgan. Please proceed.

Alex Smith – JPMorgan

Thanks guys. Just a question, Kieran, on the autosetting category. Obviously, it is the fastest growing category in the US. Do you think that is simply a case that the product is taking share out of the other autosetting devices on the market or that that category itself is growing as a total proportion of the market?

Kieran T. Gallahue

It is all of the above. I believe we are taking share and I believe that the market is continuing to recognize the power and the efficacy and the cost effectiveness of applying autosetting technologies to patient care.

Alex Smith – JPMorgan

And I guess a follow-up to that. Has the price premium that you realized on autosetting devices changed or is that still holding?

Kieran T. Gallahue

It remains the premium priced product in our CPAP/APAP line and the premiums are – that’s sort of a moving average over the last couple of years. There has been some ASP reduction in all products over the last several years. Certainly, the Autoset has also experienced that. I’d say on percentage basis, probably not that big a change. A dollar basis, obviously, it would be less as the ASPs change. But really I think it is about the power of the autosetting technology. We have done quite a bit in the last year to improve the way that we communicate the difference. In the past, we talked about it quite a bit. We tried to educate using clinical papers as an example and those are powerful tools and they are very accurate and substantial tools, but we’ve also found ways that we could use tools that can demonstrate for individuals exactly how those algorithms are working and how they compare to competitive technologies, and we’ve enabled our sales reps to be able to do that demonstration. So, we found that the more the customer understands the difference between our autosetting technologies and others, and the difference between autosetting technologies and CPAP, the more prone they are to consider Autoset as a solution for their patients.

Alex Smith – JPMorgan

So, this is completely independent of home sleep testing, possibly driving a shift towards APAP?

Kieran T. Gallahue

I think at this point, it is independent, but I think you make a good point that as home sleep testing rolls out, we believe strongly that the autosetting technology can play a very important role in cost effectively delivering the home sleep testing solution over time, so I think that is yet to come, the benefit of that.

Alex Smith – JPMorgan

Great. Thanks very much guys.

Operator

And your next question comes from the line of Jason Mills with Canaccord Adams. Please proceed.

Jim – Canaccord Adams

Hi, this is Jim [ph] for Jason. Two quick questions. One is on international, can you give us your estimate for international market growth?

Kieran T. Gallahue

Yes. Historically, what we’ve said is we believe the market internationally is growing somewhere in that 10% to 15% range and we’ve said in the last several quarters, we think it is probably closer to the 10% range. I think that we feel comfortable saying it has stayed around that level and if it wasn’t for just a slight timing bump in the ventilation side of the business, I think you would have seen it there.

Jim – Canaccord Adams

Okay. And the second is just on the macro economic environment. I know you said you didn't see any in this calendar Q4, but qualitatively are you hearing anything from Sleep Lab in terms of them decreasing any of their estimates or beds or anything like that?

Kieran T. Gallahue

It is a question and, obviously, we got a lot of these questions over our Q3 or last quarter, as so many different businesses and so many different healthcare businesses were impacted by the economy. We said then we continue to believe, which is we simply were not seeing the impact that others in the healthcare community and general business environment were seeing. So, I guess my summary is we remain cautiously optimistic. Keep an eye on it, but feeling good at this point.

Jim – Canaccord Adams

All right, thanks a lot. Good quarter guys.

Kieran T. Gallahue

All right. Thank you.

Operator

Your next question comes from the line of Ben Andrew with William Blair. Please proceed.

Ben Andrew – William Blair

Good afternoon. Can you guys hear me?

Kieran T. Gallahue

Yes, sure can.

Ben Andrew – William Blair

Great. Kieran, maybe two questions if I may. First, maybe one for Brett. Can you isolate the trend in gross margin by the end of the fiscal year and just forgetting about currency, I know there’s a lot of moving pieces, but absent that, you are still comfortable with getting north of the 60% range or is it going to take you a little longer to get some of the benefits from mix and manufacturing?

Brett Sandercock

The manufacturing improvements obviously take longer term to flow through because they've roll through inventory and then inventory has to be sold and so on. But we’re actively working on all of those and certainly not all of that would be through in this fiscal year, certainly as you look through FY 2010 you’ll certainly see benefits and you have things – even Singapore manufacturing for example, as that ramps up, that will still improve our cost base, particularly if you look through FY 2010. There are a number of actions we’re undertaking independent of the currency that is purely designed to improve our margins and to make us more competitive. And then, overlying that obviously is margin improvement from the currency which has really been a headwind for us for the last few years as the currency ramped up the Aussie dollar. It’s really coming back to what you consider more historical levels or historical range. I mean, the (inaudible) $0.90 happened last year and didn’t happen since the mid-80s over that level. So it was really aberration I believe in the Aussie dollar. But having said that, I’m not trying to predict currency; they are extremely volatile. We’re in a range that’s probably more of a historical context.

Ben Andrew – William Blair

Okay. That sounds focused. Obviously, it’s a multi-year process to push that gross margin but the aspect of the question I’m really asking is, two years out, Kieran, structurally, if you didn’t get any more tailwinds from currency, for example, where would the gross margin be in your view? Would it be static or would it be lower or higher?

Kieran T. Gallahue

We still believe that we have opportunities for margin expansion. If I go back to what we talked about two or three quarters ago, about the various areas that we were focusing on to drive margin expansion and part of it was cost savings. Part of it is design of products and the way that we design new generations of products. Part of it is cost savings throughout via the system overall and of course, it’s also investing in innovation because one of the key ways of maintaining margins over time is bringing innovative products to markets that means something to the patient and means something to the customer. It’s one of the reasons why we continue to invest so heavily within R&D and why we’re so pleased with the progress that we are seeing with the SPU’s leadership of those teams. So we’re not counting on currency at all.

Ben Andrew – William Blair

I understand. It's a combination of product mix in those manufacturing synergies, but what everybody is really trying to figure out is, is there going to be yet another structural shift in price over the next two to three years beyond your ability to out-innovate that would structurally hurt the gross margins? I understand what you’re trying to do with the business and you’re controlling the things you can control. That’s sort of what I’m trying to understand a little bit better.

Kieran T. Gallahue

My viewpoint – I understand, of course, none of us have crystal balls, right? But, if you look at historically this industry and you look where it has moved, there’s a couple of very positive signals in my opinion for this industry. One is the price movements we saw last year were quite unusual. The kind of things you only see maybe every five years at best.

The second part is I think it has helped that we’ve had Phillips introduce itself into this industry. It’s a business that historically has been known to compete on innovation and market expansion, not on price, right? Now, you’ve got two players that represent a good 80% of the market who both believe in market expansion, in driving innovation, and in creating value within that industry. I think that’s a good thing for the long-term health of this marketplace.

And on top of that, you have this continued recognition and understanding of the role that sleep-disordered breathing plays in very, very costly co-morbidities such as diabetes and congestive heart failure, right? So, I think we’re pushing in the right places. The industry structure has evolved in a very positive way. We’ve got the innovation and the product line that, in my opinion, serves this market very well and suggests that we should see a very solid, very comfortable market here in the coming years.

Ben Andrew – William Blair

Okay. That’s helpful and the last thing I’ll ask is the international growth, about 8%, that sort of falls at the lower end of the range of expectations for that business over time, what were the issues, if any, in the quarter? Was this sort of a difficult comparison or is Germany coming back? Just maybe talk about international events.

Kieran T. Gallahue

Sure. So we’ve got some markets that are doing incredibly well in the international market. Japan and France did very well in the last quarter. UK did very well. So we’ve got some real big winners throughout that. The big issue we had last quarter as I reflected before was ventilation. Remember ventilation is really mostly a European business, a little bit in Asia; it really doesn’t influence the Americas much at all. We had that VSIII introduction where we didn’t start shipping in this quarter, so you just had a sort of a short-term anomaly there and I think that the ventilation business overall is one that we’re certainly going to keep a close eye on simply because it’s a loaner pool market and there’s always the opportunity to look at depreciation cycles of these products, etc., but it was really an isolated situation that we think we can bounce back from.

Ben Andrew – William Blair

Great, thank you very much.

Operator

Your next question comes from the line of Michael Matson with Wachovia Capital Markets. Please proceed.

Michael Matson – Wachovia Capital Markets

Hi, question on your R&D spending. It was up quite a bit on a constant currency basis. Just wondering if we can expect it to stay that high for the remainder of the fiscal year? And if the Australian dollar was to strengthen, is that something that you could reign back in if you needed to?

Kieran T. Gallahue

Yes. Sure. Thanks for the question. So, remember in the R&D line, in addition to core product development, we also have the SERVE-HF clinical study and that’s just to remind everybody that is the clinical study that we have been engaged in multinational, multisite, that is focused on the use of adaptive servo-ventilation in heart failure patients. So it’s sort of rolling through and it wasn’t in any material way on the base year, so that represents part of that growth that we’re seeing and certainly like all clinical studies, those are the things that you can review from time to time and make decisions on what you want to do with them.

As far as the rest of the R&D line, we certainly have the ability to adjust that should we decide but I'll reflect back on the comment that Brett made. Our intention is to continue to invest in R&D throughout the economic cycle. We strongly believe that innovation is critical in this marketplace to continue expanding it, to maintain very solid and appropriate margins throughout this, and for us to enjoy the market share that we enjoy. So, we certainly do not have any intentions of taking the foot off the accelerator, although we always have that option should we decide to exercise it.

Michael Matson – Wachovia Capital Markets

Okay and then with regards to the economy, I know that you’re not seeing an impact so far, but do you think you would see a greater risk with the US or the international markets? And with your product segments mask versus flow generators, which of the two do you think of the two are more economically sensitive, if you will?

Kieran T. Gallahue

Real hard question to answer, right? What we’ve seen throughout the globe is we’re not seeing that the economy and the challenge because it’s already affecting people throughout the globe, we’re not seeing differential impact in one market versus another. I suppose you could look at Australia which is a very, very small market for us but that’s a private pay market. Conjecture, I’d say maybe that would be one that might be a bit more under pressure. But in the other markets, we are seeing reimbursements (inaudible) government. We are seeing reimbursements through a mixture of government and private pay, so I think there are some pretty common dynamics there and again, I think that’s worked in our favor.

Michael Matson – Wachovia Capital Markets

Okay. Thanks.

Operator

Your next question comes from the line of Dan Herron [ph] from UBS. Please proceed.

Dan Herron – UBS

Good morning. I just want to ask a question in regards to the mix shift. We’ve been hearing a little bit about the changes of compliance rules in the US and it’s driving home healthcare dealers towards the higher-end products with a bit of data logging capability. Just wondering if you can comment on that and where it is headed (inaudible) or is there more to come?

Kieran T. Gallahue

Yes. That’s a great question. There is a lot of good things that are happening from the perspective of product mix in that category. So basically, we refer [ph] to particularly in the Americas, the US, CMS was stepping up its requirements on how it was requiring HMEs to collect and report compliance and how compliance was defined. Quite frankly, that plays in our favor and it plays in the favor of HMEs that focus on good care too. So, the idea of that is you need to be able to collect this information in order to prove compliance over time. The way that our systems are designed, when you download the information for instance with a card, all right, the information continues to reside on the flow generator itself. So, let’s say you measured compliancy, you have your card and something happens to it. It breaks, it bends, it falls in the garbage, whatever. You lose $8.

Our competitors, when you download the information onto their card, it stays with the card. So that card gets lost. If it fails, if something happens to it, it’s gone. The information is gone. So the cost is not $8, it’s the ability to capture the revenue that’s associated with the billing of that. So that might be an $800 or a $1,000 card that you just lost, in essence, right. So the way that we’ve designed our systems with that redundancy, that natural redundancy has been recognized by HMEs because they realize it reduces their risk in today’s environment. So very, very positive changes as far as we’re concerned.

Don Herron – UBS

And just potentially as follow-up, is there potential with this rule changes and with the move toward the data logging higher-end devices, is there a potential for the lower-end manufacturers in the market who don’t have that capability to be pushed out margin-wise at a time?

Kieran T. Gallahue

I think it’s a difficult place to be if you’re in that part of the market. This is – you got a bit of Moore’s Law going on here and you’ve got systems that are highly capable. A good example of that is the bi-levels, the auto bi-levels which is an absolutely phenomenal product. We’re hearing rave reviews from sleep physicians who in some cases have dramatically increased, as in 4x, the percentage of their patients that they’re putting on bi-level because the auto bi-level is so comfortable, all right, very, very powerful. The VPAP Auto 25 is what I’m talking about. Now, the low-end machines where you are just not collecting data, you’re not able to provide the information that is required by CMS and likely to be followed by other insurance companies, you can't do it, then you can’t even be considered. So these changes play to our favor and we’re already seeing that happening.

Don Herron – UBS

Okay, thanks.

Kieran T. Gallahue

You bet.

Operator

Your next question comes from the line of David Stanton with ABN AMRO. Please proceed.

David Stanton – ABN AMRO

Thanks guys. Could you tell us if there’s any updates or do you have any more color on the (inaudible) position in the US in terms of, I guess, private insurers and/or infrastructure? Any color on that would be appreciated, thanks.

Kieran T. Gallahue

I’m sorry. Was that home sleep testing you’re asking about?

David Stanton – ABN AMRO

Yes, that’s right.

Kieran T. Gallahue

Yes, great. So this has been a fascinating and a critical last 12 months for home sleep testing in the United States. I mean, it’s always important for us to sit back for a second and reflect over the last year. And basically, what occurred in the last year is CMS has said home sleep testing is here. It’s here to stay, and now it’s a matter of how we roll it out, and when it gets rolled out. And so, it’s was very critical year last year. And of course, on the private payer side, four of the five largest private payers also jumped onboard. So, CIGNA, Aetna, Anthem, United, and of course, Medicare, all have recognized and have accepted home sleep testing.

So what we’re looking at this year is, there is a lot of pilots, I guess is the best way to say it, that are going to be rolling out throughout this year. It’s going to be the year of 'how' sleep testing. So last year was the year of 'if' sleep testing and clearly the answer was yes. This is the year of 'how'. And you see our partners, for instance in the sleep community, trying to enact what our Chairman has been talking about for years which is the hub-and-spoke model. They have been trying to live that hub-and-spoke model and understand how they can, for instance, recapture leakage in the system and let me tell you what I mean by that.

About 30% of patients who get a referral into a Sleep Lab, never show up. That is an historical number; nothing new about that. And the reason they don’t show up frequently is because either they don’t want to go through the overnight sleep study or there is something to do with the economics, etc. Something tells them that they’re not going to show up. That's a perfect use of home sleep testing, so we have certain sleep positions that have been saying, “You know what, we’re going to go to those referral sources and we’re going to try to use home sleep testing as part of that mix." And they’re doing so recognizing that they’re going end up with more PSGs as well, because a number of those patients who get home sleep tested, either because of co-morbidities or because of complexities, are still going to need a PSG. So they’re looking at implementing it that way.

You now also have other healthcare providers that are trying to understand what their role may be; independent diagnostic testing facilities, these IDTFs. You probably are going to see PCPs, the primary care positions and to a certain extent other medical specialties taking a look at it. So, I think this is going to be the year where we’re going to be watching a lot of these models rolling out. And you’re going to see technologies that are introduced that will help support that process.

David Stanton – ABN AMRO

Thanks very much. I appreciate it.

Operator

Your next question comes from the line of Helen Cameron with Citi. Please proceed.

Helen Cameron – Citigroup

Good morning guys. I’ve got two questions that’s around the pricing environment, revenue. I guess the 9.5% cuts come through went off now [ph]. How should we be factoring this into our projections going forward? Do we assume you get 2% less from the bank there? And also on the relationship with HMEs and yourselves, is there sort of a horse trading going on there as to who gets more in terms of the dollars booked in the bank going forward because clearly there, I guess, are some issues going on there, as the HME gets more involved in patient management and get more leverage of our [ph] end user?

Kieran T. Gallahue

Good question. If we go back to what you were referring to, which is the Medicare cut of 9.5% which went across a number of different products, not just sleep products, including oxygen and med neb and diabetes supplies, etc. That was all announced back in July and actually there was a sigh of relief from the HMEs when that came through because it took a lot of the questions about what is going to occur in it and it make it very specific. So, it is not new news starting January 1; that has already been sort of worked into the behavior of the customer dynamic over the last six months.

One of the thing that is interesting about these kinds of cuts is the last time there was a significant cut on oxygen and med nebs, which was about three years ago, it actually preceded one of the biggest growth spikes that we had seen on sleep side and the reason is, these HME are businesses. They've got a lot of fixed infrastructure; these big logistics teams, be it in personnel or be it in buildings, etc., and they need to grow their way out of these kinds of challenges. So when they look around their business, what are they going to do? Look to oxygen to grow? That is more a zero sum game or it's market stealing that is going on there. They look at sleep and they see the opportunity for expansion.

So we have had a lot of conversations just as we did three years ago when you started to involve more of these HME about, "How do I win in this environment? Tell me how I sell sleep even more? Can you help me with materials so that I go to my referring physicians and I can teach them about the links with diabetes? I can teach them about the links of cardiovascular disease. Help me understand on how I can ship more masks. How do I get from shipping 1 every 16 months to a customer to try and replace on a more appropriate cycle that insurance supports because it is good medicine? How do I do that and what are some of the tools?" So these changes where you look at them and on the surface, they could say – you can step back and say, "Oh-oh, what is coming down here?" The reality of what we have already lived several years ago and what we are hearing from our customers is, we actually think this is an opportunity for stimulating growth because HMEs are businesses and they need to grow themselves out of this.

Helen Cameron – Citigroup

Are you seeing any shift – just as a follow-up on med, on the relative sharing of the pie between yourselves and the distributors? Are they getting tougher in terms of sharing the dollar revenue at the end of the day?

Kieran T. Gallahue

No. There hasn't been any changes in their behavior and certainly not with change in the Medicare pricing.

Helen Cameron – Citigroup

Right. So what you are seeing about the revenue line and the 9.5% cut? It is really I shouldn't add another 2% – sorry, reduce that by 2% going forward into 2009 because it is basically already been absorb in renegotiations post July?

Kieran T. Gallahue

Yes. Historically, we have always said that in this marketplace, you look somewhere 3% to 4% price decline over the course of the year and then some years, it is bigger and some years, it is less. Clearly what we experienced last year was a bigger year and I think that puts us in good position as we come into this year. So I'd say there is nothing unusual about what's going on right now.

Helen Cameron – Citigroup

Okay, thanks for your help.

Kieran T. Gallahue

You bet.

Operator

Your next question comes from the line of Matthew Prior with Merrill Lynch. Please proceed.

Matthew Prior – Merrill Lynch

Good day guys. Just a first question in terms of some visibility emerging of US Health Policy with the new administration. Can you just comment on increased coverage, especially in terms of diagnosis and how that would affect the market in the US and also in terms comparative effectiveness with funding for studies (inaudible) $700 million?

Kieran T. Gallahue

Change in the administration, the short answer is, certainly at this point we are not seeing anything that changes for our industry. Like everything else, we'll have to keep a watching brief on it but certainly nothing new news with the change in the administration at this point. Most of the changes that we’ve seen from a legislative point in the last year have been actually quite positive. I think the biggest change we’ve seen out of the legislative, certainly coming down from CMS has been the introduction and the validation of the use of home sleep testing, and it’s being pushed because what they’re trying to do is to make sure that they are spending appropriately, that you’re using the most cost-effective way of reaching the most patients possible.

The good news for sleep is that we are involved in some of the most expensive co-morbidities on the planet. You look at diabetes, you look at heart failure, we are right in the center of that. And the data that came out within this last year, or the validation because the data has been coming out for years, quite frankly, but the validation of the data by world bodies, International Diabetes Federation, European Society of Cardiology have said, “You know what, CPAP is the gold standard treatment for sleep disorder breathing. It is a cost-effective way of getting in there and treating these patients. You should be looking for these breathing disorders in those patients.” So, I think the way that things are playing out here bode well for us because we are good healthcare and by treating sleep disorder breathing, it is a cost-effective way of treating patients. We are, in my opinion, and in our opinion, we are where you want to be in healthcare right now.

Matthew Prior – Merrill Lynch

Thanks. And just tying that into my follow-up question, you had a very strong US quarter and obviously, that was devices and masks. I know that there was obviously both upgrade sales in there from existing patients and new patients also. If it’s upgrade sales, then it echoes to compliance and that’s great for, obviously, home testing and if it is the key patients, it increases the installed base. Can you just give us some indication as to of that growth, which was greater? Upgrade sales from existing patients or new patients coming onboard?

Kieran T. Gallahue

We really don’t have visibility to break that out for you. We sell to the HMEs and the sleep physicians. They jealously guard their patient – as they should, their patient lists, and so we don’t get into discussions in order to get disclosure about what percentage is to existing customers versus to new customers. I will say that over time, existing customers are becoming more and more important and that’s a good thing because as the pie of diagnosed population continues to grow, they represent the opportunity for annuity streams; and of course, those annuity streams, primarily mask and accessories, are the highest profitability parts of our product line.

Matthew Prior – Merrill Lynch

Thanks. A follow-up on that one. Do you track, obviously, the metric of masks per device as a metric of compliance?

Kieran T. Gallahue

It’s a faulty measure of compliance because you can use masks and flow generators independently of one another; you don’t sell on a one-to-one basis. So using that as a proxy can be a very confusing way and, in fact, a misleading way of making some assumptions on that ratio.

Matthew Prior – Merrill Lynch

Sure. Thanks, guys.

Kieran T. Gallahue

You bet.

Operator

Next question comes from the line of Todd Harrison [ph] with Credit Suisse. Please proceed.

Todd Harrison – Credit Suisse

Thanks for taking my call. Just a quick question. You mentioned the ApneaLink product that now meets regulatory requirement. I’m just wondering, is that an area that you’re now looking to compete more heavily in the home diagnostic side with home diagnosis coming through?

Kieran T. Gallahue

Well, we’ve had the ApneaLink product now for a number of years. In fact, it was developed by our German subsidiary and we’ve continued to expand off that base, so our intention is to continue investing in that platform. It is a very sensitive, very accurate device, incredibly easy to use, and the advantage that it has is many of the home sleep testing devices that exist today were very complex devices that the manufacturers are trying to strip down in order to meet the, let’s say, the type III as an example, the type III testing requirements, which means they have the infrastructure of a much more expensive unit. We, on the other hand, have built from the simplistic and have been adding feature sets over time. In fact, the type III device, we intend to introduce before the end of the year. So, it puts us in a very good position because it’s both easy to use, which is what you want in a home care environment. It is very accurate, very sensitive, which is what you want out of a device, and it is very cost effective. So it positions as well. But when push comes to shove, diagnostics from our perspective is still the enabler; therapy is what the long-term business model is really built on.

Todd Harrison – Credit Suisse

Okay. Thank you.

Kieran T. Gallahue

All right. Thanks.

Operator

We are now at the one-hour mark, so I will turn the call back over to Kieran Gallahue for his final remarks.

Kieran T. Gallahue

Thanks, Eric, and thank you all for joining us, as always. And also, as always, I want to thank our employees all over the globe and in our various functions for what was clearly their stellar efforts that drove ResMed’s performances last quarter and, in fact, over the course of our history. So, I want to say thank you to all those employees and I can tell you that we’re all very excited about our future here. We’ve got high-margin, exciting new products growing out over the course of the next year. We’ve got new policies that have been approved for the use of home sleep testing, new national accounts contracts to implement. We’ve got a very, very strong balance sheet with excellent cash flow and once again, we have an absolutely stellar team to continue on the execution. So, a lot of good things going on in the company and the industry. I want to thank you all for joining us and we look forward to updating you on future calls. Thanks everybody.

Operator

And thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: ResMed, Inc. F2Q09 (Qtr End 12/31/08) Earnings Call Transcript
This Transcript
All Transcripts