Temporary Softness For ResMed

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

-Competitive bidding impact ebbs
-Gross margin impressive
-Rest of World, new products supportive
 

By Eva Brocklehurst

ResMed ((RMD)) remains confident the competitive bidding process, round 2, in the US will not be a problem for growth in mask sales. In its first quarter update the sleep disorder specialist noted US industry revenue growth should still be around 6-8%. The September quarter was always going to be important for visibility in terms of the impact of competitive bidding and management expects price and volume disruption will dissipate over the coming months.

So why did the stock sell off? First quarter sales growth was softer than many had expected and this spooked the market. That's all it was, according to Macquarie. Nonetheless, the broker concedes that, in constant current terms, sales growth of only 4% is not consistent with a stock that's trading around 20 times FY14 earnings forecasts. Most brokers suspect the softness won't last. Competitive bidding headwinds will weaken now that the riskier aspect of price negotiations has passed, while new providers will sort out the logistical issues. Macquarie also notes the company's business in the rest of the world is solid and underlying market conditions look positive.

BA-Merrill Lynch maintains that, if the company was able to deliver 14% earnings growth in a quarter affected by such a material event as competitive bidding, then it's a very positive outcome. Given that the areas of specific disappointment previously were with the rest of the world, and that seems to be recovering, the stock remains worthy of a Buy rating. The valuation is not stretched either, based on Merrills' current forecasts.

Merrills looks beyond the first quarter weakness and finds the company scores a positive mark in three out of four areas. The US is the area where the broker is most cautious and flow generators in that market could endure further downside, but this is unlikely to be a major problem. The three areas with upside potential are growth in the rest of the world, new products and gross margins. Macquarie was also impressed with the company's ability to achieve strong gross margins, despite the pressure from competitive bidding. Moreover, the company has upgraded guidance on margins for FY14 to 62-64%. The gross margin was 63.7% in the quarter. Macquarie observes that margin expansion is being driven by product mix as well as manufacturing and supply chain efficiencies, which should be supportive in the months ahead, notwithstanding the tailwinds recently coming from exchange rate movements.

ResMed lost market share in masks as a result of new products introduced by competitors, and this appears to have accelerated during the quarter, according to Citi. The recent launch of the Quattro Air full face mask and the Swift FX Nano nasal mask, and other mask launches scheduled for the next 3-12 months, should mitigate this loss of market share but it might take several quarters. UBS disagrees. The broker is unable to detect any meaningful movement in market share, despite the speculation regarding fragmentation towards the less comprehensive offerings of the smaller manufacturers.

Sales were a little softer than UBS expected and US flow generators may contribute to stock overhang throughout FY14. UBS expects the impact of competitive bidding will largely be contained to FY14, from which FY14 will be re-based. The broker has previously surmised that, even in the event of stagnant US flow generator sales, the company could grow earnings by 15% over the next five years. This is a result of increased mask consumption in the US, supported by reimbursement arrangements.

ResMed also has considerable flexibility in the product launch timetable. The company has the luxury of launching products when they are needed to support growth and not simply when they are ready to market. UBS notes replacement products are not launched until the outgoing product is exhausted and reaching unacceptable levels of market share loss or price decline. The broker maintains that the market has focused too much on market pricing and not enough on the earnings impact. Price is only one input driving the complex profit story for this company.

UBS has decided the time is right to upgrade to Buy from Neutral, taking the number of Buy ratings on the FNArena database to seven. Credit Suisse has the lone Neutral rating. The consensus price target is $6.18, suggesting 15.9% upside to the last share price. The price target has eased from $6.38 ahead of the first quarter update. Price targets range from $5.90 to $6.62.
 

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