Resmed: Recall of Defective Units Eating Into Profits

Jun. 8.07 | About: ResMed Inc. (RMD)

Resmed is a medical device company that makes sleep aid machines. Many people suffer from sleep apnea that is caused by constriction of air flow inhibiting breathing. This can have serious side effects if left untreated for a long time and RMD is one of the few companies addressing this need. According to the company’s quarterly report, the global market for sleep aid services is $2 billion and growing, yet this market has been less than 10% penetrated leaving ample room for growth.

The company competes primarily with Respronics Inc (RESP) and both companies have similar size as defined by market cap. RESP has recently gained market share by severely cutting prices on its masks and it is assumed that they lost money on each unit sold but were willing to do this to gain more inroads with doctors who prescribe these units for patients. Although one could consider the market a duopoly, there is intense competition right now which is having an effect on the profitability of each company.

RMD has run into some rocky ground as of late partially due to the fact that they found some of their units had a defect that could cause the machine power supply to overheat with the potential of a fire. A recall followed this discovery which is costing the company an estimated $60 million dollars (without the recall, the company would have made $42m pre-tax). The company is trying to make the best of this recall by highlighting their commitment to consumer safety, but this will likely drive more customers and physicians to try competitors products.

I am concerned that this stock trading at a 30 multiple is likely to lose its “growth” designation as sales growth seems to be easing and earnings are contracting even without the recall situation. While I applaud the company for spending significant amounts on R&D to beef up their product offering, that spending is eating into profits and in a severely competitive market, margins could contract to make it more difficult to spend as much on this development. If growth investors begin to get tired of this name or simply choose to focus more on RESP, the multiple on the stock could drop to 20 very easily which would mean prices south of $35.00.

A key data point will be next quarters earnings announcement. Analysts and investors will be listening to hear if margins are picking back up, if the recall is going to cost less than expected, and if there are any new products that will stimulate more demand. If all 3 of these points are not addressed I think you will see the stock slip quickly. I currently hold a short position in our fund and would caution investors to tread with caution in this name until more of these questions are answered.

Disclosure: Author has a short position in RMD

RMD 1-yr chart