By Jake King
ResMed Inc. (RMD), a developer of continuous positive airway pressure (CPAP) devices, is suing fellow CPAP manufacturer and low-cost competitor 3B Medical for patent infringement. But ResMed's motives for the lawsuit are more aggressive than defensive in our view, and we believe that ResMed is well aware that the CPAP market is beginning to work against its successful but aggressive marketing efforts. PropThink has been skeptical of RMD's ability to sustain its meteoric bottom-line growth for a few reasons, including drastically reduced government reimbursement on CPAP devices following two rounds of competitive bidding from the Centers for Medicare and Medicaid (CMS) and the company's high gross margins, which will have to change if the top-line takes a hit. (Read our prior report for details) The news that ResMed is making a concerted effort to stifle a new low-cost competitor is in-line with our belief that RMD has found its top and that management is well aware.
Investors have come to expect stellar growth from ResMed, hence the company's rich P/E multiple; RMD trades at 21 times 2013 EPS estimates vs. peer comparison companies trading, on average, at 17 times 2013 EPS estimates. And macro headwinds are rising against the company's lead product lines, nasal CPAP devices and masks. While the company reported modest upside to EPS expectations in the first quarter of 2013 (RMD's Fiscal 3Q), revenues missed analyst expectations, the first sign that growth prospects are at risk when the Medicare Competitive Bidding reimbursement cuts kick in (July 2013). More troubling than the revenue shortfall, the company's lead growth driver, sales of nasal CPAP masks, has slowed in both the U.S. and in international markets. The Centers for Medicare and Medicaid Services now requires masks to be replaced after an inspection supports replacement, not on an arbitrary schedule as they were being replaced prior to the regulatory change. As we, and other writers, have outlined in the past, CMS reimbursement rate changes won't be the sole hurdle to ResMed's continued growth. The slowdown in mask sales, pressure on overall prices from lower-cost nasal CPAP equipment manufacturers, and the risk that private health insurance companies follow the CMS rate cuts could cause RMD to lose share and/or put significant pressure on sales and margins. Should RMD's earnings prospects turn from strong growth to flat, or even decline, we believe the stock could fall sharply. Simply using the average P/E of mid-cap medical device companies, 17x, implies that RMD could trade down to the $38 level.
Is this lawsuit about more than infringement? 3B produces low-cost and non-branded CPAP equipment and launched its product lines in the U.S. just eight months ago into a market currently dominated by ResMed and Philips Respironics. Privately held 3B, a branch of BMC Medical, has been growing rapidly since launch in response to what they consider a quickly changing market. 3B's Sales Manager Susan Craig in a March interview affirmed our view that Durable Medical Equipment (DME) suppliers are under strong pressure to lower costs following the latest round of CMS cuts, and that less expensive products are the simplest solution. 3B's commercial strategy relies in-part on these CMS changes steering DME and HME (Home Medical Equipment) suppliers in search of less expensive CPAP technology. Most of 3B's devices sell for nearly half the price of ResMed's, and, reading between the lines, the fact that ResMed is directly targeting a low-cost competitor with a patent infringement suit is telling. It seems the Wall Street Journal's recent article "Cashed-Up ResMed Mulls $1 Billion Question" speculating on RMD's capital use could also include initiatives to stave off competition using legal pathways.
On Friday May 31, 3B Medical reported in a press release that ResMed filed a lawsuit alleging infringement "on claims covering the elbow swivel of a nasal pillow mask and the water flow back valve of a humidifier." Alex Lucio, Vice President of 3B, said in response:
This lawsuit is the newest in a series of similar suits aimed at limiting new market entrants into the sleep market. 3B/BMC alleges the lawsuit is intended to do little more than erect huge hurdles to market entry by forcing crippling litigation costs. At least, that is what it looks like on the surface...we have never knowingly traded off of another company's intellectual property. Our success is based on our own research, design, engineering, and low cost manufacturing.
It gets more interesting, however, as 3B doesn't plan to take the lawsuit sitting down:
As corporate policy, 3B/BMC will vigorously defend any IP challenges. A cursory review of the lawsuit finds little merit to the claims asserted in the complaint. Further, in order to allow the marketplace to decide the victor, 3B is proud to announce a series of paid for advertising which will explain the true manufacturing costs of the items in this product space. 3B/BMC believes that once the marketplace understands true manufacturing costs, branding at the expense of unconscionable profit margins will no longer be supported or tolerated by an industry being squeezed with reduced reimbursements. 3B/BMC believes that ResMed's motive has little to do with defending legitimate intellectual property claims and more to do with using crippling litigation costs to reduce market competition. 3B/BMC intends to fight, both in court and in the marketplace. [emphasis is the author's]
The competitive bidding process was undertaken to rein in spending and potential over-use in the home health area (see Amedisys (AMED), Humana (HUM)), and for 3B to make public the true costs of CPAP products could have a real effect on prescribers and distributors alike. 3B will be making a public display of the high margins that the CMS is working to discourage, and implicating ResMed along the way.
Mask sales, a key growth driver, slowing due to CMS changes and competition. ResMed derives over 55% of its revenue in the U.S. from sales of its CPAP masks (patient interfaces), and this component has been a major driver of growth for the company. However, given the new CMS changes that lessen the turnover rate of masks used by chronic CPAP patients on Medicare, and new competitive products gaining traction, growth of RMD's mask products is slowing. The company reported year-over-year mask growth in the U.S. of just 8% last quarter, down from 21% growth in the quarter a year earlier. Also troubling, sequential growth of masks appears to be leveling off; masks generated $118M in F2Q13 compared to $119.8M in the most recent quarter (F3Q13). On the slowdown, Executive Chairman Peter Farrell said:
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 Fisher Paykel 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.
Competition heating up as CMS reimbursement cuts are starting to have an impact on Durable Medical Equipment (DME) and Home Medical Equipment (HME) suppliers. ResMed on its latest earnings call mentioned rising competition from both Philips Respironics and Fisher Paykel, two of the larger branded competitors in the nasal CPAP segment. These companies have new products going out to the market and are also dealing with the CMS reimbursement cut pressures, and both have the wherewithal to adjust prices to gain share. But in addition to the new products from Philips and Fisher, ResMed neglected to mention smaller emerging competitors that also appear to be gaining traction in the space; for example, 3B Medical. As a result, significant headwinds are mounting against ResMed's growth, and we believe the company may be surprised by the confluence of issues heading its way.
In response to one analyst's question on pricing pressure, Mick Farrell, ResMed's CEO, said on their last conference call:
...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 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 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.
We note that this "business-as-usual" attitude could be dangerous as Round 1 of competitive bidding only impacted 9% of the metropolitan statistical areas planned for this competitive bidding, while Round 2 will affect the other 91%. Plus, Round 1 reduced prices by ~34%, which compares very "favorably" to Round 2's whopping 47% reimbursement cut. That 47% cut puts enormous pressure on many of ResMed's DME and HME customers. Comments made by a number of DMEs and HMEs at the recent Medtrade conference in March indicated that cheaper CPAP products were gaining share as the medical equipment suppliers (DMEs and HMEs) struggle to maintain a profit, let alone stay afloat. As the Competitive Bidding reimbursement cuts move closer, and ResMed's business faces a multitude of competitive and pricing risks, we believe caution is warranted.
Management continues to sell stock, signaling the top. Reading signs from the people who know the company best would suggest to us that it's time to trim positions. Insiders have sold more than $43M in stock since last November, over $10M in the two months since our last report noted the insider sales. Perhaps most telling was Executive Chairman and CEO Peter Farrell's sale of 400,000 shares at the end of January. That transaction grossed $18.8M, but more importantly, the shares were sold at prices between $46.75 and $47.53, the same range at which RMD trades today. We believe that management is aware of the increasing pressure on the business, and their selling is simply another sign that the company's rich P/E multiple won't last forever.
As we've said before, investors should take cues from management and grab a seat before the music stops. Based on consensus estimates (expected earnings of $2.25 in 2013), RMD trades at a P/E multiple of 21x forward earnings, a top-tier valuation compared to medtech industry peers that average 14x for large-caps and 17x for mid-caps. The market has been willing to attribute a rich valuation multiple to RMD due to the company's robust performance since 2006. But if CPAP wholesalers and providers begin to rein in spending with the 2nd round of competitive bidding this July, RMD's top-line growth begins to slow, and investors look for the next high-growth story, RMD's P/E multiple should begin to contract to more closely resemble the rest of its segment. At 17x forward earnings expectations, RMD is more appropriately valued around $38, a ~20% decline from today's prices.
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