ResMed’s Margin Upside Excites

This story features RESMED INC. For more info SHARE ANALYSIS: RMD

Sleep treatment leader ResMed has faced a number of headwinds but has surprised analysts with a strong improvement in gross margins.

-ResMed’s weaker mask sales offset by stronger device sales
-Gross margin improvement surprises to the upside
-Weight-loss drugs not seen as a major threat
-More capital management ahead

By Greg Peel

At the Margin

If it wasn’t enough that investors had been scared away from ResMed ((RMD)) with the explosion of GLP-1 drugs (which treat diabetes but have the added benefit of reducing weight, therefore, in theory, reducing incidences of sleep apnoea), the effective closure of the Red Sea due to Houthi attacks on shipping significantly increased ResMed’s freight costs to Europe.

Analysts have a different spin on the GLP-1 effect, which we’ll get to shortly, but the highlight of Friday’s result was a better than expected increase in gross margins, upon which freight costs are a drag.

A “miss” in device sales (vis a vis analysts’ forecasts) was offset by a beat on mask and accessory sales, leading to an earnings result that either matched or exceeded analyst forecasts.

Gross margins lifted in the June quarter to 59.1%, well ahead of consensus, despite the freight headwinds. This was attributed to a range of offsetting margin tailwinds, including (i) manufacturing improvements; (ii) procurement initiatives; (iii) increasing scale benefits, such as overhead recoveries; (iv) manufacturing efficiencies as ResMed transitions to the AirSense11; (v) mix shift, in particular masks versus devices; and (vi) new product launches such as AirFit F40, with other mask launches to come.

In Jarden’s view, there is further upside in gross margins as freight normalises, with the potential to move beyond pre-covid margins.

Furthermore, headwinds from elevated component costs incurred in prior periods continue to unwind, underwriting a stable to growing gross margin position for FY25-26.

While the Red Sea issue is not resolved, and freight cost headwinds will continue for now, gross margins are expected to lift in FY24 as mix, price and manufacturing efficiencies continue.

ResMed is guiding to a 59-60% gross margin in FY25, ahead of consensus, providing analysts with confidence.

Moreover, the miss on mask sales was not a great surprise given ResMed was cycling a 30% mask sale increase year on year.

Taking GLP-1s Head On

GLP-1s such as Ozempic have taken the world by storm as the ultimate weight-loss drug, even if that was not the original intention. But they are expensive, and if you stop taking them you put the weight straight back on. That is an impediment to begin with.

Obesity commonly leads to sleep apnoea, hence GLP-1s are seen as undermining ResMed’s customer base.

However, the flipside is that increased attention to weight-loss has actually boosted recognition of sleep apnoea as a related problem and the availability of masks and devices to treat it.

While anti-obesity drugs could displace continuous positive airway pressure (CPAP) devices in some patient categories, suggests JPMorgan, the evidence to date continues to point to complimentary usage and higher CPAP adherence.

To that end, Morgans notes ResMed is aspiring to become a leading digital health “sleep concierge” by leveraging its strong data analytics around megatrends in consumer wearables and Big Pharma’s focus on weight loss drugs, helping patients better access information on screening, diagnosis and treatment.

“We are confident,” says Wilsons, “that system growth in sleep will go up when Big Pharma (including Eli Lilly) win OSA [obstructive sleep apnoea] labels for GLP-1 receptor agonists and start the inevitable Do You Have Sleep Apnoea?’ campaigns.

Wilsons highlights Eli Lilly, as the Big Pharma company recently released a paper appearing in the New England Journal of Medicine touting its Surmount-OSA drug, which the broker describes as a powerful demonstration of the obvious (that weight loss begets improvement in OSA symptoms) and nothing more.

“We see it as a relatively contrived clinical vignette,” Wilsons continues, “which may win a label expansion for Lilly, but says nothing about how the obese OSA patient experiences and manages their disease using CPAP. CPAP will remain standard of care for the foreseeable future”.

JPMorgan, in the meantime, remains “confident the growing availability of GLP-1s, including having OSA on label, will be a tailwind for sleep demand for at least the next 12 months”.

Capital Management

ResMed’s cash generation was “very attractive” in the June quarter, notes Jarden, with working capital releasing cash flow via inventory balances. As a result, the company’s cash is achieving a speedy reduction of debt, with ResMed set to emerge debt free in FY25.

More importantly, it opens ResMed up to increasing dividends (up 10% on the March quarter), larger buybacks and M&A. The latest $50m buyback guidance per quarter in FY25 looks a little soft to Jarden and serves only to offset the dilution from staff equity. However, the broker would expect this to become more meaningful once debt has been fully extinguished.

ResMed continues to mention M&A but the focus appears to be on small “tuck-in” acquisitions for the time being.

Positive Views

One other issue hanging over ResMed in past years has been the anticipated re-entry into the market of competitor Philips, after the competitor was forced to recall its devices. The re-entry has taken much longer than originally assumed, but it will happen, eventually.

This has been a particular bugbear of Citi’s. ResMed has greatly benefitted from Philips’ withdrawal in gaining market share over the period, and cementing itself as the global leader in sleep treatment, which many analysts believe will be hard to undermine. Citi has long forecasted that when it does return, Philips will gradually regain around 20% of device market share, and take 10% of that away from ResMed.

Despite dismissals elsewhere, Citi also assumes GLP-1s are a headwind to demand for CPAP devices over several years.

Citi retains a Neutral rating, lifting its target to $34.00 from $30.00 post the June quarter result.

UBS also retains Neutral, and complicates the issue by setting a price target for the US-listed stock at US$210.

Ord Minnett also acknowledges potential risks to ResMed from weight-loss drugs, but the market’s conclusions on the impact of these drugs is too “downbeat” in the broker’s view. Ord Minnett also suggests the benefits to ResMed from the Philips recall have also not been fully discounted by the market.

Ord Minnett retains an Accumulate rating, lifting its target to $35.40 from $33.00.

Morgans has an Add rating, and lifts its target to $35.93 from $34.11.

Macquarie (Outperform) continues to see ResMed as attractive at current levels, given solid earnings growth over time, a favourable balance sheet position and valuation appeal at the current multiple. Macquarie raises its target to $36.25 from $35.40.

Morgan Stanley (Overweight) is the other broker monitored daily by FNArena covering ResMed, but has not yet updated on the June quarter result.

The consensus target among the above brokers is $35.06, with four Buy or equivalent ratings and two Hold ratings.

Not monitored daily, Jarden (Overweight) has lifted its target to $33.83 from $32.85, and JPMorgan (Overweight) has lifted to $37.00 from $34.50.

Ahead of the pack, Wilsons’ (Overweight) target rises by 12% to $40.25.

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