ResMed Inc. (NYSE:RMD) recently posted first quarter earnings that were largely within my expectations. However, despite nudging my revenue growth expectations higher (based upon long-term trends in obesity, an aging population, and diagnosis rates), I am lowering my expectations for earnings growth as it becomes apparent that rational pricing may be less of a factor than I had thought previously. Increased competition may predispose the noninvasive ventilation ("NPPV") market to diminished pricing power amongst its participants, and switching costs may be less robust than I had previously thought. After adjusting my discounted cash flow model to account for this, I am modestly lowering my fair value estimate, and see shares as essentially fully valued at the current time, without any significant margin of safety.
Operating Results:
| Last Quarter | 1 Year Ago | Change Year to Year | Change Year to Date | |
|---|---|---|---|---|
| Consolidated Revenues | $380,399,000 | $357,662,000 | 6.4% | 3.2% |
| Gross Margin | 62.4% | 63.7% | -136 BPS | -4 BPS |
| Operating Margin | 24.9% | 27.1% | -220 BPS | +68 BPS |
| Net Margin | 21.9% | 22.6% | -74 BPS | +120 BPS |
| Earnings per Share | $0.58 | $0.56 | 4.9% | 11.6% |
Though revenues improved modestly, in line with my long-term expectations, margins were compressed across the board, with gross and operating margins off by over 130 and 220 BPS year-to-year, respectively. Revenues were strongest in ex-US markets, growing at a robust 11% on a constant-currency basis, with US sales posting a +3% gain year-to-year. Sales of flow generators (+8% worldwide, +11% ex-US) accounted for nearly the entirety of the gain, with sales of masks actually declining by about 1% for the quarter. Management pointed to impairments in price and adverse product mix that were more than sufficient to offset improvements in manufacturing techniques and the supply chain. Diminished pricing was driven by aggressive price drops by ResMed's competitors, including Phillips Respironics, which started dropping its prices in late 2013, forcing many other companies to follow suit. ResMed was no different, and for the better part of the past year, one could find multiple ResMed masks models retailing for 10% to 20% off peak prices.
Operating margins in turn were also affected by an 80 BPS increase in SGA costs, as the company renewed aggressive marketing efforts, partly to drive patient awareness and maintain volumes but also partly for new product innovations. Research and development costs also increased by about 100 BPS year-to-year to 7.9% and are forecast by management to hang in this range going forward as the company continues to burnish its product pipeline and move into new areas like medical informatics. Offsetting the negative impact of this diminished pricing power and operating efficiency was a more favorable tax rate (-170 BPS y/y), and EPS were further juiced by share buy-backs (835,000 shares bought back at an average price of $51.38).
| Last Quarter | 1 Year Ago | Change Year to Year | ||
|---|---|---|---|---|
| Book Value Per Share | $11.59 | $11.64 | -0.4% | |
| Net Current Asset Value per Share | $6.16 | $6.30 | -2.2% | |
| Tangible Book Value per Share | $9.24 | $9.36 | -1.28% | |
| Current Ratio | 6.04 | 2.55 | 136.7% | |
The company's balance sheet remains tremendously strong, though challenges to the company's growth were perhaps more apparent here. Though the company is far from overly leveraged (with a current ratio over 6), BVPS, NCAV/S, and Tangible Book values all were flat to slightly negative, as the company accumulated over $300 million of long-term debt that more than offset substantial accumulations of cash.
| Last Quarter | 1 Year Ago | Change Year to Year | Change Year to Date | |
|---|---|---|---|---|
| Operating Cash Flow | $86,536,000 | $90,425,000 | -4.30% | -5.64% |
| Capital Expenditure | -$23,047,000 | -$18,431,000 | 91 BPS | 40 BPS |
| Free Cash Flow | $63,489,000 | $71,994,000 | -344 BPS | -279 BPS |
Unsurprisingly, with challenges to the bottom line, free cash flows were off substantially. Capital Expenditures held steady on an absolute basis (+90 BPS as a percentage of revenues, year-to-year), and combined with a modest increase in working capital to diminish free cash flow.
When discussing the company's product pipeline during the earnings conference call, management pointed to previously discussed growth drivers - increased OSAS diagnoses, changing reimbursement strategies by insurers - but also pointed to a variety of new applications and therapy modes for NPPV. The company continues to see opportunities in respiratory care for chronic cardiorespiratory disorders like COPD and CHF, though trials there are ongoing and previous trials (of bilevel for COPD and CPAP for CHF) have been heterogeneous in their success levels. ResMed has seen increasing utilization of auto-PAP machines, and envisions growing volumes in this area as diagnoses of OSAS and other sleep-disordered breathing syndromes begin to climb and insurers look for ways to accomplish home testing. Finally, the company is investing heavily in medical informatics, which may serve to leverage information gathered by its machines to generate usage trends that may be used, in turn, by sleep physicians and health insurers, as well as improve the overall efficiency of NPPV setup and titration. All in all, the company looks to be building on its already sizable portfolio of patented technologies and intangible assets, and to be taking advantage of its already significant share of the NPPV marketplace.
Assessment and Outlook:
I view the company's operating results as a bit of a mixed picture. Long-term demographic trends appear to be intact, and it appears that I and others may have been too conservative with prior estimates for the explosion of obesity in the US and abroad. With additional therapeutic applications for NPPV sure to come, growing physician awareness of obstructive sleep apnea, and an increasing number of inexpensive ways to diagnose the disease, it seems reasonable to expect the NPPV market to grow even faster than had been previously expected. This augers well for ResMed, and an adjustment to my revenue growth assumptions seems reasonable. I am further pleased, though not surprised, by the company's continued commitment to research and development, and think that its dive into medical informatics (with the ResMed Data Exchange, for example) could potentially yield a minor network effect in time, further solidifying the company's competitive advantage. I would be concerned, however, about the apparent diminishment of pricing power shown this quarter, which suggests, on the one hand, that the NPPV market is in danger of losing any sense of rational pricing, and, on the other, that patient switching from ResMed to a competitor may not face the same total costs as before - particularly as competitor's products become more user-friendly and tolerable - indicating a commoditization of the market. Whereas an upward revision to my revenue growth estimates seems reasonable, I would probably temper my view of the company's future operating margins accordingly.
Valuation:
After adjusting my discounted cash flow model to account for this quarter's results, I am lowering my fair value estimate for the shares from $57 to $54, with an uncertainty range of $49-$58. I use a statistically weighted average of the results of a discounted cash flow model ($54), historical valuation model ($55), and earnings growth model ($39) to achieve my result. For my discounted cash flow model, I now assume 9-10% top-line growth over the next 5 years as diagnoses of OSAS accelerate and new indications for NPPV arrive. I predict margin counteracting this revenue growth, as increased competition diminishes ResMed's pricing power even further, and see gross margins decreasing by about another 100-200 basis points over time. Though I do expect the company's marketing and R&D efforts to continue, the company should eventually be able to benefit from growing scale and I would expect SGA expenses as a percent of revenues to diminish over time. As a result, I envision operating margins to eventually settle around 27%, and EPS to grow at a 5-year 9.5% CAGR. I continue to utilize a cost of equity assumption of 9.5% and weighted average cost of capital of about 8.2%. Model data are reproduced below.
| 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | ||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Revenue | $1,643,066,327 | $1,835,781,618 | $2,043,245,805 | $2,266,624,045 | $2,385,760,513 | $2,499,238,453 | $2,541,847,065 | $2,556,329,159 | $2,554,926,752 | $2,537,680,892 | $2,504,984,322 | 0.04307 |
| Cost of Revenue | $637,282,133 | $713,308,208 | $791,458,048 | $885,690,030 | $935,810,310 | $983,922,974 | $1,003,987,074 | $1,009,687,185 | $1,012,407,616 | $1,008,809,850 | $999,036,949 | |
| Gross Profit | $1,005,784,193 | $1,122,473,410 | $1,251,787,757 | $1,380,934,015 | $1,449,950,204 | $1,515,315,479 | $1,537,859,991 | $1,546,641,974 | $1,542,519,135 | $1,528,871,042 | $1,505,947,373 | |
| Operating Expenses | $527,175,033 | $591,025,701 | $655,653,956 | $734,810,340 | $776,741,876 | $817,349,685 | $834,374,260 | $842,317,897 | $844,958,878 | $842,346,446 | $831,530,406 | |
| Operating Income | $478,609,161 | $531,447,709 | $596,133,801 | $646,123,676 | $673,208,328 | $697,965,794 | $703,485,731 | $704,324,077 | $697,560,258 | $686,524,596 | $674,416,967 | |
| Taxes | $110,335,544 | $122,556,294 | $137,490,109 | $148,995,859 | $155,176,879 | $160,934,723 | $162,223,091 | $162,397,186 | $160,828,487 | $158,320,500 | $155,480,829 | |
| Net Income | $368,273,617 | $408,891,414 | $458,643,692 | $497,127,816 | $518,031,448 | $537,031,071 | $541,262,640 | $541,926,891 | $536,731,771 | $528,204,096 | $518,936,137 | |
| Depreciation & Amortization | $89,929,318 | $96,441,356 | $103,994,594 | $111,509,370 | $112,884,249 | $113,494,236 | $111,029,938 | $107,221,454 | $102,730,720 | $97,655,691 | $96,389,035 | |
| Operating Cash Flow | $458,202,935 | $505,332,770 | $562,638,286 | $608,637,186 | $630,915,697 | $650,525,307 | $652,292,577 | $649,148,345 | $639,462,491 | $625,859,787 | $615,325,172 | |
| Capital Expenditures | $87,248,892 | $104,000,022 | $117,294,194 | $127,156,766 | $137,261,569 | $147,101,296 | $152,341,943 | $149,867,834 | $146,389,537 | $141,963,032 | $140,133,453 | |
| Free Cash Flow | $389,055,608 | $407,057,093 | $449,816,639 | $484,403,094 | $499,292,401 | $511,989,578 | $508,279,237 | $504,593,167 | $495,440,770 | $482,997,394 | $474,293,423 | |
| Discounted Cash Flow | $359,673,115 | $376,315,080 | $384,439,592 | $382,732,899 | $364,703,674 | $345,734,404 | $317,307,358 | $291,216,135 | $264,339,526 | $238,238,227 | $216,276,861 | |
| Operating Margin | 29.13% | 28.95% | 29.18% | 28.51% | 28.22% | 27.93% | 27.68% | 27.55% | 27.30% | 27.05% | 26.92% | 0.28037 |
| EPS | $2.58 | $2.87 | $3.33 | $3.67 | $3.90 | $4.11 | $4.22 | $4.30 | $4.33 | $4.34 | $4.34 | |
| Tax Rate | 23% | 23% | 23% | 23% | 23% | 23% | 23% | 23% | 23% | 23% | 23% | |
| Gross Margin | 61% | 61% | 61% | 61% | 61% | 61% | 61% | 61% | 60% | 60% | 60% | |
| Net Margin | 22% | 22% | 22% | 22% | 22% | 21% | 21% | 21% | 21% | 21% | 21% |
My fair value estimate implies a forward price-to-earnings ratio of 21 times and an EV/EBITDA ratio of about 13.5, relative to a current EV/EBITDA ratio of 12.9. With shares currently trading in the mid $50s, I view them as fully valued, without a margin of safety at present.
Quantitative Analysis and Conclusion:
| Free Cash Flow Yield | 5.2% | ||
|---|---|---|---|
| Calculated FCF Growth | 1.5% | ||
| FCF Total Return | 6.8% | ||
| Expected Earnings Growth | 5.33% | ||
| Dividend Yield | 2.14% | ||
| Anticipated EPS Total Return | 7.47% | ||
| Median ROIC/WACC | 1.5 | ||
| Morningstar Moat | Narrow | ||
| Fair Value Estimates | DCF: $54 | Hx: $55 | $39 | Consensus: $49 |
| Estimated Fair Value | $54.00 | ||
| Margin of Safety | 3.61% | ||
Long term, I view ResMed as being able to reliably drive mid-single digit total returns. I view obesity and aging as nigh-unbreakable demographic trends, and given the overall cost-effectiveness of NPPV for treatment of the respiratory consequences of diseases related to these conditions, I think the industry at large is set to benefit. ResMed's operating advantages, including its many intangible assets and growing scale, suggest that it should be around to reap the benefits of these trends for a while, but I worry about its pricing power and think that increased competition will eventually commoditize the industry and weigh on meaningful margin expansion. As a result, I am cooling my view of the shares, and would look for a more sizable margin of safety before committing money to the name, seeking an entry point in the $45 range to accumulate, and possibly initiating a full position below $40.
Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The author is not a professional financial adviser. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.
