ResMed Management Discusses Q3 2013 Results - Earnings Call Transcript

Apr.25.13 | About: ResMed Inc. (RMD)

ResMed (NYSE:RMD)

Q3 2013 Earnings Call

April 25, 2013 4:30 pm ET

Executives

Constance C. Bienfait - Director of Investor Relations

Peter C. Farrell - Founder and Executive Chairman

Michael J. Farrell - Chief Executive Officer and Director

Brett A. Sandercock - Chief Financial Officer and Principal Accounting Officer

James Hollingshead - President of Americas

Donald Darkin - President of SDB Strategic Business Unit

Geoff Neilson - President of Respiratory Care Strategic Business Unit

Robert Douglas - President and Chief Operating Officer

Analysts

David C. Clair - Piper Jaffray Companies, Research Division

Ben Andrew - William Blair & Company L.L.C., Research Division

Michael Matson - Mizuho Securities USA Inc., Research Division

Matthew Prior - BofA Merrill Lynch, Research Division

Ian Abbott - Goldman Sachs & Partners Australia Pty Ltd, Research Division

Anthony Petrone - Jefferies & Company, Inc., Research Division

Jeffrey Chu

Operator

Welcome to the Q3 2013 ResMed Incorporated Earnings Conference Call. My name is Trish, and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

I would now like to turn the call over to Constance Bienfait, Director of Investor Relations at ResMed. Constance, you may begin.

Constance C. Bienfait

Thank you, Trish, and thank you all for joining us today.

The company has asked me to address certain matters. First, ResMed does not authorize the recording of any portion of this conference call for any purpose.

Second, during the conference call, ResMed may make forward-looking statements such as projections of future revenue or earnings, new product development, new product launches or new markets for the company's products. These statements are made under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Risks and uncertainties exist that could cause actual results to materially differ from forward-looking statements. These factors are discussed in ResMed's SEC filings, such as Forms 10-K and 10-Q, which you may access through the company's website at www.resmed.com.

[Operator Instructions] Speaking on the call today are Peter Farrell, Executive Chairman; Mick Farrell, CEO; and Brett Sandercock, CFO. There are also other members of the management team present that will be available to answer questions.

I would now like to turn the call over to Peter Farrell. Peter, please go ahead.

Peter C. Farrell

Okay. Thank you, Connie, and thanks to everyone for joining us. After this call, I'll turn over responsibility for the handling of future quarterly earnings calls to Mick, who the board appointed as CEO, which most of you would have come across last month.

And as an aside, let me point out that we had a 2-year search, which the board conducted under the auspices of Spencer Stuart, and we examined both internal and external candidates. And the decision was made, as I said, last month. So I'll review the quarter, and then Mick, who's currently in London, will join the call and make some brief remarks before we hand over the call to Brett Sandercock to go through the numbers in more detail.

So first, the financial summary. As you would have seen from the press release, we finished another solid quarter. This represents the 73rd consecutive quarter in which we've grown the top line and obviously, we're extremely pleased about that. Global revenue in the third quarter grew 10%, both actual and constant currency numbers to $334 million. Revenue in the Americas grew 13% year-over-year to $215 million, and ROW revenue increased 6% compared to the year-ago quarter. And that also was in both actual and constant currency terms, and that was to $168 million.

We believe that these results were from as a result of both superior product quality and full solution offerings. And these 2 aspects continue to drive our growth.

Net income for the quarter increased 31% to $85 million while GAAP EPS increased 32% to $0.58 per share for the quarter. Excluding amortization of acquired intangibles, EPS was a record $0.59, which showed excellent operating performance.

The global growth in Flow Generators this quarter was primarily driven by our high-end devices with strong sales of AutoSet, bilevels and adaptive servo-ventilation, as well as in Respiratory Care with the Stellar. We believe we continue to take share in the AutoSet space, and we are also gaining share back in bilevels. In short, our respiratory products are being well-received.

And there is plenty of room for us to continue to grow in all these areas. For example, in the Americas, where Flow Generator sales were particularly strong this quarter, we had the S9 AutoSet, bilevels and VPAP Adapt, which of course is our adaptive servo-ventilator in the U.S., all did particularly well. And we attribute a lot of the share gains and mix shift to both the positive responses to EasyCare Online and to increases in home sleep testing, which I will discuss in a little more detail.

Turning to the rest of the world. There is still a lot of uncertainty in Europe. However, we were gratified with the results in both the U.K. and Germany. So despite the challenging economic climate throughout Europe, as well as fiscal constraints, the focus is still on treatment that keeps patients out of hospital and healthy. AutoSet CS, again our ASV offering in Europe, VPAP ST and Stellar products did well again this quarter in most parts of Europe.

The Asia-Pacific region also had a solid quarter, with strong sales in Japan and India, although as we've explained on a number of occasions, Japan sales are inconsistent from quarter-to-quarter. And in this particular quarter, Japan was a little soft though, but not unexpected. Japan ended this fiscal year end, and these distractions that is Teijin, ended their fiscal year on March 31. And those distractions tend to affect their sales during this quarter. And as I said, they're a little softer but not unexpected.

As I mentioned, EasyCare Online, the compliance management system, continues to be well-received. And we are seeing solid uptake from both existing, as well as new accounts. And the EasyCare Online, I should point out, is also now available for bilevels.

In this challenging environment, where there are changes in government reimbursement, coupled with mandates to bring down the cost of health care, products and programs, which provide superior therapy and better compliance, what bring the most value across the board to patients, customers and payers.

Now with respect to interfaces, masks, our growth moderated due to -- and I think a number of you referred to this new entrance into the marketplace. However, Mask parts and accessories did very well in all geographies. But complete Mask systems sales were, in fact, a little softer. Both Philips and F&P have 2 new masks, as most people are aware. And as expected, they are being trialed by various customers. This is not a new experience for us. But as you know, we've been experiencing particularly good performance and market share gains in all of our Mask categories for quite some time. So things do tend to change.

But more recently, the new competitive offerings, as I've already mentioned, are being tried by some of our customers. We are of a view, however, that these new entrants are not nearly as good as ours, but they are gaining traction as HMEs are willing to, as I said, try them.

But perhaps equally importantly, or arguably more importantly, we faced a tough comparison to last year's third quarter's -- last year's third quarter, where growth in the Mask category in the Americas was 21%, and globally, it was 16%. So in short, a pretty big mountain to climb.

However, as always, we plan to stay ahead of the game by constantly innovating. We provide -- we are going to provide, in the very near future, mask products that are smaller, quieter and more comfortable, and which we believe will keep us well ahead of the game.

Our product pipeline is actually quite full, and we are releasing 2 considerably improved mask products this quarter with more to come during the remainder of fiscal 2014. In fact, we are extremely optimistic about these new interface innovations.

Now coming back to home sleep testing. The number of commercially covered adult lives requiring pre-authorization for PSG continues to roll out, steering providers and patients towards HST. It is now well over 50% of covered lives and heading north. We estimate that at the -- or we estimate that at the end of calendar 2012, approximately 25% of all tests were HST, and we believe -- or our numbers are showing that this will be around about 40% at the end of our fiscal year June 30.

We continue to see a steady increase in the number of sleep labs involved in HST, averaging approximately 38% during the last 12 months, with a rise to around 47% in January in response, again, to pre-authorization. We are also participating in primary care physician awareness initiatives as HST continues to advance. In fact, PCPs are becoming more involved with the diagnosis and management of the sleep apnea patient and are also starting to drive momentum in the whole of the sleep business.

So sleep market is not just about selling equipment to treat sleep-disordered breathing, it is very much about forming partnerships with both customers and payers. A combination of our range of high-quality Flow Generators, the most comfortable and effective masks and accessories and easy to access robust data through the EasyCare Online, makes us an excellent value proposition.

Not only do we have a robust pipeline of new masks, we have future technology innovations planned for both sleep and Respiratory Care. In short, we are at the forefront as leaders in innovation in the sleep space, and we have every intention to continue to bring to market the best possible solutions for sleep-disordered breathing.

Finally, as I have said before, given recent data, which suggest that SDB, sleep-disordered breathing, affects approximately 25% of the adult population at some level and that the treatment -- the diagnosis and treatment of SDB, firstly, improves quality of life; secondly, slows co-morbid disease progression; and finally, reduces health care costs. It is, as I have said before, the holy grail of health care delivery.

With that, I'll turn the call over to Mick. Are you ready to make some comments, Mick?

Michael J. Farrell

I am. And thank you, and hello from London. This is a really exciting time for our team here at ResMed and not just because we had a Q3 revenue of $384 million, which represented 10% top line growth and 31% net income growth. However, with the fast growth of the global health care spend and its growing share of the GDP burdening many major global economies, both governments, as well as private payers are looking for answers to reduce the cost of the health care and to improve patient outcomes.

We believe that at ResMed, we have the answer to these questions in the fields of sleep-disordered breathing, as well as Chronic Obstructive Pulmonary Disease or COPD and in other cardiorespiratory areas, particularly heart failure. I'd like to take just a couple of minutes to discuss 3 major growth horizons that we see in our future here at ResMed.

The first growth horizon for ResMed is in our core SDB business. In the last 12 months alone, we have impacted many millions of lives in this space, resulting in around $1.5 billion in revenue. We will continue to grow the number of lives we impact each year along with our revenue. We are the global SDB market leader. We've talked before about SDB as a solid growing market and one that is incredibly underpenetrated.

At most, it's 5% to 15% penetrated, meaning that 85% to 95% of the opportunity in our core business is still in front of us. As the global SDB market leader, we're in a great position to drive new market penetration and new market growth, geographically and to other co-morbidities, as you just heard.

We've said it before. Our biggest competitor is not one of the other SDB manufacturers. It's a lack of education and awareness of the signs and symptoms of SDB, as well as the ability for physicians, particularly PCPs, to have practical medical action pathways. We're investing in changing that and ensuring that we have sustained, strong growth in our core SDB market.

The second growth horizon for ResMed is our Respiratory Care business. This fast-growing business includes diseases such as COPD, as I mentioned before; neuromuscular diseases, such as ALS also called Lou Gehrig's disease.

This Respiratory Care opportunity includes hospital and homecare ventilation, as well as hospital and homecare humidification. We have a leadership position in Western Europe with homecare ventilation. However, in the U.S. market, we have significant room for share growth. Combining Respiratory Care opportunities in the U.S. with those significant ones in Asia-Pacific, as well as Latin America, we have revenue growth potential in the multiple hundreds of millions of dollars. And there are many, many millions of patients with COPD and neuromuscular disease whose lives can be significantly changed with innovative ResMed technology.

In that vein, we've just announced today, as you saw another press release in these last 24 hours, that we are launching the first and only bilevel device cleared by the FDA specifically for the treatment of COPD, one of the top 5 killers in the Western world. COPD sufferers now have a weapon in their fight to stay out of hospital. One of the biggest challenges for COPD patients, as well as their payers and physicians and for the health care providers that we serve, is to keep these patients from returning to the hospital after a COPD exacerbation event.

More than 1 in 5 COPD patients are rehospitalized within 30 days. VPAP COPD has all the features of our higher-end noninvasive ventilation devices, including access to our cloud-based software system, EasyCare Online. EasyCare gives physicians, payers and HMEs the opportunity to monitor COPD patients, as well as our core SDB patients, it's the same platform, and intervene if there's a problem and potentially reduce cost and reduce rehospitalizations.

Our third growth horizon is in the field of cardiorespiratory disease, but specifically cardiology and even more specifically, heart failure. As many of you know, we're running a large multinational randomized controlled trial or RCT in the heart failure space called SERVE-HF. SERVE as in a tennis serve and HF for heart failure. SERVE-HF is evaluating approximately 1,300 patients and is wrapping up enrollment over the coming weeks and months.

In this 2-year follow-up study, we are looking at 2 primary outcomes: mortality and morbidity. We're cautiously optimistic that the data from SERVE-HF are going to show that ResMed's proprietary technology can save both lives and money, so to reduce the mortality and to reduce the morbidity. This is an enormous opportunity in the market space where heart failure and SDB intersect.

At ResMed, we believe we have the best products, the best team and the winning strategy. We care about the health and the quality of life of our patients. We care about disease prevention. We care about improving outcomes, and we care about improving the economics of our somewhat broken health care systems. We are more excited than we have ever been that despite the challenges of current health care market dynamics, we at ResMed have the capabilities and the product pipeline to really make a difference.

You'll hear me echoing many of the same things you've heard from Peter Farrell over the last couple of decades: our belief in ResMed's people, our world-leading product quality, our laser-like focus on innovation as well as solid science and clinical validation. Most important though is our shared vision for these 3 growth markets. We are proud to be leaders in SDB. And as you heard earlier, there is still so much room for growth in that space.

I'm really looking forward to partnering in the office of the CEO with Rob Douglas, our COO, and with the rest of our CEO operations team, as well as with the almost 4,000 strong ResMed global team as we continue to drive increased value for our shareholders.

The bottom line is that we have defined business plans, specific identified investments and key ResMed business leaders who are accountable for driving success in these 3 growth horizons I've talked about: SDB, Respiratory Care and cardiology.

So with that, I'll turn the call over to Brett, who's in Sydney, to review Q3 in more detail. Brett?

Brett A. Sandercock

All right. Thanks, Mick. As we mentioned, revenue for the March quarter was $383.6 million, an increase of 10% over the prior year quarter and also 10% in constant currency terms. Income from operations for the quarter was $96.1 million, an increase of 26% over the prior year quarter. Net income for the quarter was $84.9 million, an increase of 31% over the prior year quarter. Diluted earnings per share for the quarter were $0.58, an increase of 32% over the prior year quarter.

Gross margin for the March quarter was 62.4%, up sequentially from Q2 FY '13. On a sequential basis, our gross margin benefited from a favorable product and geographic mix and manufacturing and logistics improvements. Looking forward, we expect our gross margin for the balance of fiscal year 2013 to be in the range of 61% to 63% assuming current exchange rates.

We continue to execute on initiatives targeted at improving our global manufacturing supply chain and logistics cost structures. SG&A expenses for the quarter were $109.6 million, an increase of 8% over the prior year quarter. In constant currency terms, SG&A expenses also increased by 8%, and SG&A expenses as a percentage of revenue improved to 28.6% compared to the year ago figure of 29.2%. Looking forward and subject to currency movements, we expect SG&A as a percentage of revenue to be in the range of 28% to 29% for the balance of fiscal year 2013.

R&D expenses for the quarter was $31.2 million, an increase of 10% over the prior year quarter. In constant currency terms, R&D expenses increased by 11%. R&D expenses as a percentage of revenue were 8.1%, consistent with the prior year quarter. Looking forward, we expect R&D expenses as a percentage of revenues to be around 8% for the balance of fiscal year 2013, reflecting ongoing investment in our product pipeline.

Amortization of acquired intangibles was $2.5 million for the quarter while stock-based compensation expense for the quarter was $10.2 million. Our effective tax rate for the quarter was 21.4% compared to the prior year quarter effective tax rate of 23.1%. The lower tax rate reflects the benefit of lower effective tax rates in our Singapore and Australian operations. We currently estimate our effective tax rate for fiscal year 2013 will be in the vicinity of 21%.

Turning now to revenue in more detail. Overall, sales in the Americas were $215.2 million, an increase of 13% over the prior year quarter. Sales outside the Americas totaled $168.4 million, an increase of 6% over the prior year quarter. In constant currency terms, sales outside the Americas also increased by 6% over the prior year quarter.

Breaking our revenue between product segments. In the Americas, Flow Generator sales were $95.4 million, an increase of 21% over the prior year quarter, reflecting strong growth in our APAP and bilevel devices. Masks and other sales were $119.8 million, an increase of 8% over the prior year quarter.

For revenue outside the Americas, Flow Generator sales were $114.6 million, an increase of 9% over the prior year quarter, and in constant currency terms, also an increase of 9%. Masks and other sales were $53.8 million, consistent with the prior year quarter.

Globally in constant currency terms, Flow Generator sales increased by 14% while masks and other increased by 5%. Cash flow from operations was $107 million for the quarter, reflecting strong underlying earnings and working capital management. Capital expenditures for the quarter was $19.9 million while depreciation and amortization for the March quarter totaled $20.7 million.

Our share buyback continues to play a major role in our capital management program. During the quarter, we repurchased 1.5 million shares for consideration of $67.3 million. For the first 9 months of fiscal year 2013, we repurchased 2.8 million shares for consideration of $115.3 million. At the end of March, we had approximately 6.1 million shares remaining under our authorized buyback program.

During the final quarter of fiscal year 2013, we intend to purchase at least 1 million shares under our share buyback program. In addition to our share buyback, our Board of Directors today declared a quarterly dividend of $0.17 per share, consistent with our previously advised dividend policy.

Our balance sheet remains very strong. Net cash balances at the end of the quarter were $672 million. And at March 31, total assets stood at $2.4 billion, and net equity was $1.8 billion.

I'll now hand the call back to our operator for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from David Clair from Piper Jaffray.

David C. Clair - Piper Jaffray Companies, Research Division

I guess first one for me just on competitive bidding. Just wondering if you can give us some color on conversations you've had with BMEs following the rate announcements?

Michael J. Farrell

Yes, David. That's a great question, and I'll probably hand over to Jim Hollingshead, the president of our Americas group to talk in more detail about the conversations as he took over the Americas during the last quarter. But to lead out on it, competitive bidding conversations have been ongoing with our customers over the last 2 years through round one that we're 2 years into and ended the conversations on, and into round 2, which as you said, the announcements came about around the -- with an apples-to-apples number, low 40% reduction versus sort of expectations in the 30s. We've had lots of conversations with our customers over these last 90 days as we have over the last 2 years, and the conversations really aren't any different than they were before, which is how do we work together, how do we find ways to get efficiencies out of the system that we can link up together to take cost out of the system, to link with our electronic data interfaces, our EDI, to get drop-ship to inventory sites, to work together to understand how we can help Medicare understand the return on investment from treating -- diagnosing and treating sleep-disordered breathing patients. And of course, the topic of price comes up, but that comes up in every discussion with our partners. To frame this, as we always do on this call, and many of the analysts who are listening to this call around the mathematics on this, and we're talking about 20% to 25% of our Americas payers are included in competitive bidding. So I guess somewhere between 10% and 12% of our global revenue could potentially be impacted by this. So there's a lot of other elements that go into the price discussion for the other 80% to 90% of the business. But Jim, do you have any further detail that you might want to share with David with regard to conversations about competitive bidding round 2?

James Hollingshead

Sure, Mick. Thanks very much for the question, David. I don't have a lot to add to what Mick said. We were obviously talking to our customers about the issue of competitive bidding round 2 frequently, and nobody's happy with the extent to which reimbursements have been cut. And it does represent a cut in reimbursement portion of their business, but I do think it's fair to say that the more sophisticated HMEs out in the market understand that -- understand a couple of things. The first thing they understand is that there's a volume opportunity if they want contracts. The second thing they understand is what they need to do is drive efficiencies into their business. And so that tends to be the kind of conversation we're having with customers, is how we can help them. As Mick alluded to, how we can help them by providing solutions and services so that they can run more efficiently.

David C. Clair - Piper Jaffray Companies, Research Division

Okay. And then just a quick one on the new Mask launches that you've talked about briefly on the call. Do you think that these -- do these address the Philips and Fisher & Paykel products that took a little bit of share in the quarter? And any additional details on -- are they nasal pillow, nasal, fullface, anything you want to share there?

Michael J. Farrell

So, David, that's a great question and one that the Philips and F&P and other competitors who are listening to this conference call would love to hear lots of details on. I don't think we're going give a lot of detail on that. I think we've said a lot in that our pipeline is very solid. We plan to launch 2 masks in this quarter, and there's a lot more in the pipeline to come. I'll hand over to Don Darkin maybe to give a little bit of color as to how our FX Series is holding up: Our Mirage FX, Quattro FX. These masks -- and Swift FX, have had incredible success for a sustained period of time, and we know that the market is sampling some of the competitive masks from our 2 major competitors. And we think that's a healthy competitive environment to have in the market. We're very proud of our #1 patient-preferred market position in the mask space, and we plan to defend it by innovating further and getting further ahead of where we were, which was in the lead. But, Don, any further color that you might want to provide David on the masks?

Donald Darkin

Thanks, Mick. David, we're pretty confident that what's coming out in the next few months is going to be more than adequate to cover what we need. I think more importantly, the actual pipeline itself over the next months, you're going to see pretty much what we've been planning on for some time now. And I think the competitive position for us will be more than adequate as we go forward.

Operator

Our next question comes from Ben Andrew from William Blair.

Ben Andrew - William Blair & Company L.L.C., Research Division

Two questions, if I might. First, on the COPD opportunity, how should we think about that in terms of revenue generation, for you all, in terms of magnitude and time frame?

Michael J. Farrell

Yes. Great question, Ben. And we have a large focus on COPD, and I'm going to hand this question for further detail on to Geoff Neilson, who's the President of our Respiratory Care group. But just to lead out there, the COPD market opportunity is huge. It's the top 5 killer in the Western world. It actually I think just jumped up to #3, ahead of stroke, which dropped down to #4 in terms of how many people it kills in the Western world. But apart from that, it also costs the system a heck of a lot of money. And that rehospitalization, as many of you know, particularly in the U.S. market, there are serious penalties to hospitals for within 30-day rehospitalization events. We think we can help the hospitals, but also really help the patients and physicians who have trouble with these exacerbated events with our VPAP COPD product. And the market opportunity is in the triple digits, but I will hand over to Geoff to provide some more color for you there, Ben.

Geoff Neilson

Ben, thanks for the question. I think if you look at the number of COPD exacerbations, which are hospitalized every year, there is getting close to 100 million -- sorry, 1 million patients every year hospitalized for COPD. Around 400,000 of these are hypercapnia COPD patients, which means that they'd be suitable for NIV treatment post discharge. Unfortunately, because of the qualification criteria here in the U.S., not all of them can be qualified for NIV therapy. So we were estimating the market given the current qualification criteria in reimbursement to be in the order of $100 million annually in the U.S. So that's -- and this product, it is really focused at what the requirement is in the U.S. As far as the time frame goes, obviously, we've got to change some practices in terms of discharge, prescribing behavior. These patients can qualify direct from the hospital rather than going to the sleep lab, and so that's not a short-term activity and we do have a sales force in the ground that we're building up who's calling on the hospitals and the discharge planners with the discharge guidelines and education material to try and change that. But it's going to be a multi-year activity to build up our fair share of that $100 million market.

Ben Andrew - William Blair & Company L.L.C., Research Division

Okay. And so from a revenue per patient opportunity, is it a typical pricing for the VPAP plus kind of a mass replenishment model or is there a different reimbursement model that allows different pricing?

Geoff Neilson

No. So this is going to be reimbursed under EO 470, which is a standard bilevel without a backup rate pricing. So this device is specifically designed to meet the FDA criteria for respiratory insufficiency device, which as the device has indicated, for COPD. But for the first time, it's possible to prescribe on label bilevel device for respiratory insufficiency and do that straight from the hospital. So it's going to be a premium to your existing bilevel devices, but it's not going to be priced at a ventilator-type pricing.

Ben Andrew - William Blair & Company L.L.C., Research Division

Okay. And last question as I have other track I want to go on but how high is the bar for another company to get a similar indication?

Geoff Neilson

I think we could expect to get our fair market share of this. Clearly, it's possible for other companies to get these indications, and we've optimized our product specifically around treatment for COPD. But it's not impossible for others to do the same thing in time.

Michael J. Farrell

What I'd add on to that, Ben, is that there's some level of sustained competitive advantage from the VPAP COPD not necessarily just in the device, but also in -- as you saw in the press release and you heard in the remarks we just made, it's linked to EasyCare Online. Having a cloud-based compliance and adherence in management system that already has its market share growing in the core SDB space linking the VPAP COPD, not only with the whole S9 platforms. So all the humidifiers, tubing connectivity but also the cloud-based connectivity is there. We think that can provide some level of sustained competitive advantage. And as Geoff said, we expect to get more than our fair share of this large opportunity in COPD.

Geoff Neilson

If I can just add to what Mick said. So many of these patients are on oxygen with our new ClimateLine Oxy tubing, and we allow oxygen to be fed in there. That means we're optimizing humidification and therefore, comfort for these patients, which means that we enhance compliance. And that also means that we're reducing exacerbations and reducing rehospitalizations.

Peter C. Farrell

And maybe you can add a little bit more, Geoff, in the sense that we've also altered some of the characteristics for inhaling and exhaling. We won't go into details there, but we've really optimized the way the unit functions.

Geoff Neilson

Yes. So we've optimize the parameters and so on in the device, specifically for COPD, to make it easy to set it up because we want this to be set up directly from the hospital and not have to go through the sleep lab.

Ben Andrew - William Blair & Company L.L.C., Research Division

Got you. Okay, and then briefly the other topic, I guess, is back to competitive bidding. Without getting too specific relative to fiscal '14, you've talked in the past about structural pricing being kind of the 3% to 4%. And then last couple of years maybe it was -- went to 6% to 8%. Is that sort of the level of expectation we should be looking at as this shakes out or is there a likelihood of a step function type of dynamic as we go through the resetting of some of these contracts ala 2007 that we can think about as people try to model both what pricing and then ultimately mix will do under competitive bidding?

Michael J. Farrell

Well, that's a good question, Ben, and I think you somehow got 3 questions in there by asking some sub questions around COPD. But the third question, competitive bidding yes, look, absolutely there -- are potential impacts on pricing. I think what we've said in past calls and at conferences and so on is that there's been sort of traditional 3% to 5% annual reduction, like-for-like reduction on products within the market. Could this push it to the high end of that range or even a little bit beyond it? Yes, certainly. I mean, that 5% year-on-year reduction in prices is something that we would present, expect and predict and plan for. Our job and this is something that our team has worked incredibly well on is to take more than that 5% or 5% to 6% out of COGS supply chain delivery. And we talk about the supply chain, meaning all the way from our factory to the delivered patient. So looking at the efficiency of the HME as well. So there could be some increased significant pressure, but it's not -- nothing different to what we've seen before and nothing that we weren't expecting and weren't planning for and have been executing on, I think, quite well through these first rounds of competitive bidding. So we see -- we think there'll be reasonably steady sailing through it, but we're ready for alternate weather reports.

Peter C. Farrell

And, Ben, just to add a little bit to that, maybe I've been smoking too much dope, but I don't recall any discussion of 6% to 8%, maybe somebody else has talked about that but there's no way ever talked about 6% to 8%. In terms of price reductions, yes.

Operator

[Operator Instructions] And our next question comes from Michael Matson from Mizuho Securities.

Michael Matson - Mizuho Securities USA Inc., Research Division

So I guess I have heard some rumblings of some price or I guess reimbursement cuts in Germany from a couple of insurance companies over there, and I guess they were sort of doing tenders or something sort of similar to competitive bidding here in the U.S. So just wondered if you could comment on whether or not you've seen that and whether or not you've won any of those tenders.

Michael J. Farrell

Mike, thanks for the question, and I'll hand over to Rob Douglas, our President and COO, to add more color. He and I have been spending a lot of time over here in Europe with our European operations team. Just as sort of a prequel to that, tendering or competitive bidding in different European countries happens on an ongoing basis. So we have tenders in places like Norway and the Nordic region that we participate in on an ongoing basis, and there has been some tendering in Germany. I wouldn't sort of put it as akin to competitive bidding, I'd put it akin to the other tendering processes that we've been managing and executing on for many years in Europe. But, Rob, do you want to provide some more detail on the specific question around tendering in Germany?

Robert Douglas

Sure, Mick. Okay, Mike, the German insurance industry is pretty fragmented. There's about 130 insurers. Even though they have been consolidating, that's still quite a lot. Recently, councils have put out request for tender, and they went through. Our competitors won those tenders, and they won them at pretty low prices that don't seem to include requirements for compliance monitoring or good patient service. We actually don't think that's very good care of the patient, and we don't think it's going to be a major trend in Germany. So we're keeping a careful eye on it, but we don't think it's the main thing for Germany for us.

Michael Matson - Mizuho Securities USA Inc., Research Division

Okay. That's helpful. And then as the market in the U.S. moves more toward home testing and the primary care physicians get increasingly involved with those tests and writing prescriptions for CPAP, is there a risk that that's going to sort of erode the portion of these prescriptions that are branded and maybe give the HMEs a little more flexibility in determining what products they use on these patients?

Michael J. Farrell

Yes, that's a good question, Mike. Certainly, with home sleep testing going from 25% of the tests to we think starting to approach 40% in the coming quarters and through the calendar year, there will be an increased influence, if you like, on the process of primary care physicians. Often, our specialist physicians still does read the study and often may make a recommendation on therapies. So the impact that specialists have in this field will not go away, but it will increase for the primary care physicians. This isn't something that is new to us, and we have been interacting with primary care physicians regarding sleep-disordered breathing for many years. We have actually some very specific programs, and I don't want to go into too much detail on this call. I don't know, Jim, if you want to provide some highlights of that, but we are working with primary care physician groups to make them aware not only of the disease state of sleep-disordered breathing, but also of the very important factor that if you're going to go from home sleep testing to positive airway pressure therapy, you're going to need to choose an algorithm that you can trust to deliver all night, every night for the rest of that patient's life. And you want to put your bet on an algorithm that has a lot of clinical validation, a lot of science and technology behind it because if you're saving money for the health care system by getting them to something that's going to keep them out of hospital, you actually want to keep them out of hospital. And the right technology is able to do that, and part of that technology is not only the algorithm, but also the data that can be taken from that algorithm, the information that we've taken to the cloud that can be used to manage that patient. And I think that's an area in terms of what I'm talking about specifically is our AutoSet algorithm and our EasyCare Online or health care informatics infrastructure. I think both of those are incredibly important factors that will weigh into the specialist but also the primary care physicians decision, and it's our job to educate them about the availability of both of those. Jim, did you have any further input or thoughts on the primary care physicians and our work with them going forward?

James Hollingshead

I just -- only a couple of things to add to that, Mick. I think that there will be a number of different models as different insurers shift to PSG to HST in different geographies and with independent physician groups, et cetera. So it's a complicated landscape. I don't think there's going to be a world where a primary care physician was utterly ignorant of sleep apnea is writing scripts for sleep apnea, right? There will always be some sort of influence model in there whether it's coming from an insurer or from a specialist who's read the study and is recommending the therapy and so on. And as Mick says, we have a number of programs underway right now, and I would say that some of them are early stage and we're experimenting. We have a number programs underway right now to drive awareness and brand awareness into the PCP space, but I don't think there's a huge risk associated with PCPs ending up as sort of arbiters in the space without knowing anything. It's really our job to educate the PCPs.

Michael J. Farrell

I'd say it's lesser risk and really an opportunity, Mike, and something that we've not only planned for but are starting to execute on, as Jim said.

Michael Matson - Mizuho Securities USA Inc., Research Division

Okay. And just -- sorry to go back to the Germany question, but I just -- one quick follow-up on that. So is this -- you mentioned that there's been tendering in other countries in Europe. Have you -- is this the first time that there's been tendering in Germany or has that been -- have you seen that happen over the past?

Michael J. Farrell

Yes, I think this is a first. Rob, you want to address it?

Robert Douglas

Sure, Mick, thanks. It has been going on in the past for quite a while quite. And as I've said, it's quite a fragmented insurance industry and while they are practically a common set of top-level rules, they have different practices in different companies and there has been tenders over the years there, and we've seen then come and go in the past as well.

Operator

Our next question comes from Matthew Prior from Bank of America.

Matthew Prior - BofA Merrill Lynch, Research Division

Just first question regards to, I guess, U.S. Flow Generators strength in the backdrop for the bidding. We've seen commentary out of Philips. In their first quarter results, they talked of a pretty tough U.S. landscape. You guys have done quite well. Can you talk about share gains, where they've been driven off the back of the informatics that you're pushing through and is that's obviously feeding into, obviously, the backdrop of competitive bidding? If I can just ask one subquestion to competitive bidding. Do you think you'll take your medicine upfront in terms of the private payers in terms of national accounts looking to negotiate now or do you truly see it staggered in line with the phasing of competitive bidding in both a CMS and the private payer sense?

Michael J. Farrell

Well, great, Matthew. So you gave me 2 questions all upfront. So we'll address them in order. So firstly, the Flow Generators share gains and then we'll get to the competitive bidding and upfront or staggered. So Flow Generators share gains. Again, I think Don Darkin might want to add some color after this, but just to start off, I think there are 3 major factors that are influencing our Flow Generators share growth. The first is home sleep testing is driving growth of the APAP category. ResMed has a leadership position in the APAP category with the S9 AutoSet device. So we're growing share in a growing category. That's point one. Point two, our S9 bilevels are now available across the board. And as you've heard from Geoff Neilson in his press release, in the last 24 hours, we added another S9 bilevel, and they're available all across the same platform. We think that we've had very strong growth across the high-end bilevels because the efficiencies that generates for our distributors, our customers and frankly, the value it delivers to the patient in terms of quiet, comfortable and efficacious therapy. And that's helped us on the VPAP ST, the VPAP Adapt, the AutoSet CS, the VPAP STA, and we believe it will help us on the VPAP COPD. The third point, as you alluded to, Matthew, is the health care informatics side. EasyCare Online and the cloud-based software that links into the VPAP COPD. We think that EasyCare Online in our core sleep disorder breathing market is driving added value for our customers that is leading to a preference for ResMed devices. And an important point on that is that is a sustainable competitive advantage, and it takes a long time to build up the capability and once you're ahead, you can continue to lead from the front. Don, any further thoughts or ideas on the Flow Gen share gains?

Donald Darkin

No, I think you covered it, Mick.

Michael J. Farrell

Okay. So the second question was around competitive bidding, and this I won't answer upfront, and I'll let Jim get to whether it's going to be upfront or staggered. I think there will be negotiations that happen on a daily basis with accounts with regard to pricing as the numbers came out over 30 days ago, we've already had many discussions with customers about -- for those who are winners, which those data only came out the number of weeks ago. So that's all public now. We know who the winners are. We can sit down and talk to them. We can bring out the playbook that we did in competitive bidding round one where we worked with winners, we helped them grow and we partnered with them on driving their ability to deliver with economies of scale. Jim, any thoughts on the question there with regard to medicine, upfront or staggered, Matthew's question on competitive bidding?

James Hollingshead

Yes, I think it's a good question, and I actually think it's a very difficult question to answer. As you say, Mick, negotiations are happening daily and the bid rates when they came out, they obviously create a ripple through the market and all of our customers' concern about reimbursement from CMS, and we're negotiating. One thing that I think works very strongly in our favor is that our products drive better compliance, and that's still a very important thing for the business model of all of our customers. And so we're going to continue to negotiate and work with our customers, both on pricing than on other things that we can do for the business. And we'll have to see how it plays out. I think we're very strongly positioned, and I think our customers recognize the value that our products bring to them, as well as our solutions like ECO. And we'll manage it as we can and we'll see how it goes.

Operator

Our next question comes from Ian Abbott from Goldman Sachs.

Ian Abbott - Goldman Sachs & Partners Australia Pty Ltd, Research Division

I was wondering -- I had a follow-up question on EasyCare Online. I'm just wondering how much of a direct revenue driver is that or is it more you actually almost give it away and then it drives the uptake in APAP and CPAP as you've talked about?

Michael J. Farrell

Yes, Ian, that's a good question and, Don, I'll hand this over to you before going too far. EasyCare Online is a software provision that gives customers chances for efficiencies, the ability to remotely manage adherence in a way that is kind of unique and certainly serious value-add. I do think there is a very strong indirect influence on their choice of a Flow Generator because of that, and so that indirect strength is there. There are some direct revenues associated with the overtime AFEs and so on that we put through there but we're really focused on the innovation part that ResMed brings to the game, which is in the medical device field. But, Don, maybe want to talk to some of the other areas like our Umbian acquisition and the opportunities that we have with U-Sleep as well.

Donald Darkin

Thanks, Mick. Yes, it is a difficult one to try and understand whether there is actual revenue directly as we add people in ECO. Clearly, it has many functions that enable us to keep those customers in a position when we need them. With Umbian, it's a slightly different situation where we are, in fact, getting revenue from the use of Umbian. And as that software package grows, there will be other opportunities for us to see and measure. But at this point, it's a very difficult one to sort of track if that's answering your question.

Ian Abbott - Goldman Sachs & Partners Australia Pty Ltd, Research Division

Yes, I was just trying to get a sense of whether -- you've had a very strong Flow Gen number this year, for this quarter in the U.S. I was just trying to get a sense of whether the EasyCare or the Umbian was a contributor there or is more just the underlying Flow Gen?

Donald Darkin

Yes. It certainly seems that way. But to actually put an exact track number on it's quite difficult at this point. And I think longer term, it will be easier to make a call on it. But for this stage, difficult.

Michael J. Farrell

So directionally, it's having influence, which is hard to quantify it, and I think is the short answer.

Ian Abbott - Goldman Sachs & Partners Australia Pty Ltd, Research Division

All right. And my second question is around gross margin. I just wondering if we can get an update on how much of your production is now in Singapore and also if you could perhaps break out or give some idea of the gross margin improvement during the quarter, how much was product mix and how much was, say, manufacturing mix?

Michael J. Farrell

I'll hand over to Rob, and then he may hand over to Brett to give more details on gross margin contribution for the quarter.

Robert Douglas

Thanks, Mick. Yes, Ian, we continue to work on product cost, both on the incremental improvements and operating costs through the manufacturing system. The shift to Singapore continues to help. Our Malaysian factory producing headgear is working well. And of course, the product design teams really have a big impact on the cost of the products through as well. In terms of the exact mix of margins effects, I'll hand that over to Brett.

Brett A. Sandercock

Yes. Thanks, Rob. So if you look at -- if you kind of look at that year-on-year in both product mix and the manufacturing logistics improvements were both significant contributors. So we kind of don't break that down blow-by-blow, but both of them were meaningful contributors to that gross margin expansion this time.

Ian Abbott - Goldman Sachs & Partners Australia Pty Ltd, Research Division

And the mix of -- and how significant is Singapore now, is that getting up to 2/3 or 70%?

Michael J. Farrell

It's on a blended basis, it'd be approaching 60%.

Operator

Our next question comes from Anthony Petrone from Jefferies Group.

Anthony Petrone - Jefferies & Company, Inc., Research Division

One on EasyCare Online. I'm wondering how penetrated EasyCare Online is among the installed base. Is that only S9, and is there a way to transition S8 users into EasyCare Online?

Peter C. Farrell

Somebody want to take that?

Robert Douglas

Yes, I'll have a crack at it.

Peter C. Farrell

Go on.

Robert Douglas

It's a difficult one to actually answer in a sense of what penetration we have today. We've got several hundred thousand patients in the system. But when it comes to reverting back to S8, we don't intend to do that. Going forward, obviously, we'll be covering all of our new products as they come out. But I guess it's just a tough, tough question to answer that in this period. Again, as we go forward, it's going to become clearer where we're at. But today, it's quite a difficult one to answer.

Peter C. Farrell

But there are no plans to go back to S8s and...

Robert Douglas

No, no.

Peter C. Farrell

There's no need. EasyCare Online is about the present and the future. And of course -- I was just going to say, and, of course, some governments such as in France are starting to mandate that you need to have compliance there and even CMS with this 90-day rule where you've got to show 30 days continuous usage. That's also part of the influence EasyCare Online is meeting or is addressing. And the S8 is -- I mean, it's being phased out, if you like, or almost has been phased out.

Operator

Anthony's line dropped out of the queue, so we're just going to move on to our next question from Jason Mills from Canaccord.

Jeffrey Chu

This is Jeff Chu filling in for Jason. I wanted to focus on your operating margins for a moment. With regard to operating margin leverage, what is the company's medium-term target for operating margins on an organic basis? And do you see M&A as a viable driver of operating margin expansion for the next 2 to 3 years?

Peter C. Farrell

It looks like Mick's dropped off in London. So, Rob, do you want to?

Robert Douglas

Yes, I think the operating margin leverage question, we'll hand over to Brett because...

Peter C. Farrell

Okay. There's a bit of a ping-pong here. So, Brett, you're being thrown under the bus.

Brett A. Sandercock

Yes. A lot -- those operating mix and targets and so on that we have is not something that we sort of publicly go out there with. But I would say -- I mean, clearly, we will look for operating leverage over time. You're certainly seeing that with, for example, SG&A spend, and you're seeing some margin expansion coming through as well. So they've really been driving out operating ratios and so on, which are in very good shape, and we will continue to do that. R&D, a little bit different. We'll absolutely invest in the product pipeline, and we'll invest on merits really from the ground up in terms of where we see gaps in the market and opportunities. So that one we look at it much more differently, if you like. But certainly, we're absolutely committed for initiative that are going to drive those operating ratios, but we're not out there on public records sort of disclosing what they are.

Jeffrey Chu

Okay, great. I have one last question. Did you pay the med tech tax during the quarter? And what are your expectations for the tax burden going forward?

Brett A. Sandercock

Yes. Jeff, we're paying a small amount, but really I think I mentioned a quarter or 2 ago really that number if you look at it annually, it would be less than $1 million. Most of our products don't fall into the device tax.

Peter C. Farrell

Basically, it's a hospital issue and some of our products that don't sell directly to hospitals will fall under the medical device tax of 2.3% on revenues, but it's happily, it's not material for us.

Operator

We're at the 1 hour mark, so now I'll turn the call back over to Dr. Peter Farrell for his final remarks.

Peter C. Farrell

Thank you very much. I'd just like to thank the team for their efforts, and once again, we have some first-class employees backed up by some first-class products, and we are very optimistic about the future. And so thank you for joining us today, and I'll leave you in very good hands with Mick and Rob operating within the office of the CEO. We have an extremely strong productive and excellent team across the globe. And so thanks to all for their efforts. And that completes the call, and we look forward to keeping you posted on our progress. Thanks, guys.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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