Australia | Aug 09 2023
A miss on the Q4 gross margin and Eli Lilly targeting the CPAP market have kept ResMed shares under selling pressure since Friday last week.
-ResMed shares been sold off sharply post the release of fourth quarter results
-Margins were the key disappointment while operating leverage was absent
-Brokers remain confident in the company's growth outlook
-Market sentiment negatively impacted by Eli Lilly trial targeting obesity and CPAP
By Mark Woodruff
Brokers were universally disappointed by ResMed’s ((RMD)) margin outcome in the fourth quarter, though revenues were around the forecast level and margins are expected to improve. Only days after the release, market sentiment received an additional hit as US pharmaceutical Eli Lilly announced a fast-tracked trial for its successful obesity drug, tirzepatide, specifically targeting the CPAP market.
To date, brokers in Australia have only responded to the June-quarter financial results, released on Friday morning, August 4, Australian time.
Wilsons suggests investors take advantage of a short-sighted post-result share price sell-off, and benefit from those market participants bemoaning the gross margin impact of success.
The FY23 gross margin of 56.5% remains -330bps below FY20 levels, with a deterioration of -30bps in the fourth quarter compared to the prior quarter, when consensus had been expecting a 30bps expansion, according to Goldman Sachs.
While a positive earnings surprise may have boosted the near-term stock performance, Wilsons asserts it would have counted for little either competitively or strategically.
Two years into competitor Philips’ product recall, Morgans notes unconstrained supply supported device growth, while masks benefited from resupply programs and new patient setups.
Citi expects Philips to return to the market in the first quarter of 2024 though the timing remains uncertain.
ResMed develops, manufactures and sells continuous positive air pressure (CPAP) devices for the treatment of sleep disordered breathing.
The company’s Respiratory Care franchise focuses on non-invasive ventilators, high-flow oxygen and mechanical ventilators to manage chronic obstructive pulmonary disease and the associated breathing disorders.
Jarden points out operating leverage was absent from the results, converting impressive 22.7% revenue growth into 7.4% profit growth, though management reassures selling, general and administrative (SG&A) costs will be managed to reintroduce some operating leverage.
Global mask and accessories sales accelerated in the fourth quarter to US$381m, with growth in both the Americas and the rest of the world (ROW) of 19% and 13%, respectively, due to wider CPAP availability and the reintroduction of patient outreach programs to stimulate new patient starts.
Management noted primary diagnosis and referral activity is well above pre-pandemic levels which may also reflect untreated patients re-entering the system to seek treatment, suggest Wilsons.
Software-as-a-service (SaaS) sales grew by 34% to US$137m on the increasing sleep set-ups and as activity levels improve in long-term post-acute settings.
Macquarie attributes ResMed's fall in adjusted gross profit margin (GPM) for the quarter to the headwinds of elevated component and freight costs, as well as an adverse product and geographic mix, such as in US devices.
Management expects a better FY24 margin due to an improvement for that mix (for masks, software and non-invasive ventilators), declining freight costs and production optimisation, as well as the move to a single device platform.
The adverse mix shift, according to ResMed, was due to a combination of strong US device sales (lower GPM) versus ROW device sales (higher GPM) as well as the intra-device mix. During the prior quarter, management noted the gross margin was propped up by US$15m in one-off ventilator sales to China, following a late covid surge in January 2023.
A fresh mask offering would help speed up the correction of Resmed’s adverse mix shift, suggests Jarden, and management has flagged a new launch (details unknown) over the next 12 months. It’s thought such a launch would also keep ResMed’s product offering relevant as Philips attempts to return to the market.
Further reasons for the soft fourth quarter margin
The gross margin in the fourth quarter was also impacted by a larger warranty provision, which is directly proportional to the increase in device sales, explains Jarden.
While lowering gross margin assumptions, Ord Minnett notes its long-term assumptions are intact and retains its 12-month target price of $39.
This broker, which white labels research from Morningstar, points out higher-cost inventory is still being sold with the full benefits of more normal freight and component costs yet to flow and suggests the company’s shares are materially undervalued.
Outlook/Emerging threats
While conceding disappointment that margins are not yet showing a more favourable development on such strong revenue momentum, Goldman Sachs believes ResMed is set to emerge from the pandemic/Philips recall with a sustainable double-digit increase in market share.
Despite much debate around pharmaceutical threats to CPAP demand in obstructive sleep apnea, this broker sees few realistic scenarios that would trouble a double-digit growth trajectory through the medium-term.
Wilsons points out investors are cautious over the defensibility of CPAP in the long term with the US-based Agency for Healthcare Research and Quality (AHRQ) recently confirming its negative stance on treatment outcomes.
Macquarie remains positive on the outlook for ResMed, underpinned by an expectation for increased new patient set-ups, with new mask launches potentially also supporting earnings growth.
Near term, this broker expects gross margin improvement and demonstration of operating leverage.
In the longer-term, Ord Minnett notes the sleep apnea market remains significantly under penetrated, while still expanding strong due to demographic trends and healthcare trends promoting digital health and provision of treatment in the homecare setting.
FNArena's daily monitoring consists of six brokers who actively cover ResMed, though UBS is yet to update research for the fourth quarter result. The average target price fell to $36.57 from $38 following the result, which suggests around 33% upside from the latest share price.
There are four Buy (or equivalent) ratings, and two Hold recommendations.
Wilsons, Goldman Sachs and Jarden are not monitored daily. All three have Buy (or equivalent) ratings and an average target of $36.92.
Overnight US pharmaceutical Eli Lilly announced the US Food and Drug Administration (FDA) had granted approval for a fast tracked trial: "The purpose of this study is to evaluate the effect and safety of tirzepatide in participants with obstructive sleep apnea and obesity who are both unwilling or unable to use Positive Airway Pressure (PAP) therapy in GPI-1 and those who are and plan to stay on PAP therapy in GPI-2."
In response, the ResMed share price has yet again come under selling pressure on the ASX today.
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