RMD - ResMed: Stock Re-Rating To 20x Forward P/E Is A Buy Opportunity

2023-09-12 11:52:41 ET

Summary

• RMD is a buy as I expect that the market will re-evaluate the stock and return it to its historical average.
• Sales for ResMed in 4Q23 increased by 23% YoY, driven by device sales and unexpected growth in mask sales.
• Gross margin pressures persist, but I anticipate that gross margin will eventually catch up with revenue growth momentum.

Overview

My recommendation for ResMed ( RMD ) is a buy rating, as I expect the market to re-rate the stock back to its historical average (pre-COVID) once everything normalizes. Specifically, gross margin should recover over time as the business mix, inventory balance, and freight costs normalize.

Business

In order to treat breathing problems while sleeping, ResMed Inc. designs, manufactures, and sells a variety of medical devices. The organization has branches and independent distributors across the globe, where they sell medical diagnostic and treatment equipment. The primary source of profitability for ResMed is its Sleep and Respiratory Care segment, which contributed 93% of its profits in FY22. Within this segment, devices make up 54% of the revenue, while masks and other products account for the remaining portion.

Recent results & updates

Sales for 4Q23 totaled $1.122 billion, an increase of 23% year over year. In the United States, device sales drove growth of 30%, which was bolstered by rising rates of sleep diagnosis, increased market share, and most significantly, vastly enhanced freight dynamics. Mask growth of 19% in the US and 14% in the rest of the world unexpectedly bolstered quarterly performance. Earnings fell short of expectations by 5% as gross margin pressures persist. As has been the trend over the past few quarters, less favorable mix and higher manufacturing costs led to a significant annual decline in gross margins of 200 basis points.

There might be many reasons why the stock fell by such a huge margin after the earnings, but I believe the weak gross margin development to be one of the drivers. Although supply chain and component issues have improved, it's discouraging to see weakening profit margins despite the positive trend in revenue growth. However, that is not to say that it will not recover. In fact, I am positive that gross margin will eventually catch up with revenue growth momentum. It's important to keep in mind the dramatic decline in freight costs since their peak, as well as RMD's ongoing efforts to rebalance distribution back towards the sea from air. The current unfavorable product mix at RMD is also putting pressure on the company's profit margins. For instance, the growth rate of device masks has been consistently higher than historical averages. Because of the drop in new patients beginning treatment during the COVID pandemic, the mask franchise's success has been lagging behind but is now undergoing a strong recovery trend. This can be seen from the fact that the rate of diagnosis has been steadily rising over the past few quarters, and in the March 2023 quarter, RMD established a new record for the number of new patient setups. This achievement has led to a necessary upswing in mask growth during the third and fourth quarters. While this is bad news for gross margin in the short term, it is encouraging to see that mask sales increased by 18% in the fourth quarter of 2023.

Furthermore, there has been a noticeable decline in inventory levels from their peak, a trend I expect to gain momentum throughout FY24. In FY23, inventory levels were more than double what they were in FY21, primarily because RMD prioritized ensuring a secure supply chain and over-optimizing working capital efficiency during the COVID period. However, in the fourth quarter of 2023, there was a decrease in this sum, which makes me cautiously optimistic that the peak of inventory growth has passed. I anticipate that we will witness actual reductions in inventory in the upcoming quarters, resulting in a larger portion of lower-cost (newer) inventories flowing into the Profit and Loss statement, thereby increasing gross margin.

Overall, It would appear that the current decline in gross margins is only temporary. While I do not expect GM to reach its recent highs anytime soon, I do believe there will be some improvement from current levels in the near term.

Valuation and risk

According to my model, RMD is valued at $177 in FY24, representing a 20% increase. This target price is based on my forecast of a growth slowdown over the next 2 years as RMD sees competition coming back from Philips (refer to my risk section) and a normalization of mask sales. However, I expect margins to increase as gross margin improves over time; specifically, the increase in mix of subscription revenue carries a higher margin; the normalization of inventory should be accretive to gross margin as well; and lastly, the continuous normalization of freight costs.

RMD valuation contracting to 20x PE is a gift, in my opinion, as I believe it does not reflect the medium-term outlook. That said, I also do not think it will revert back to +30x anymore. If we look at the period pre-COVID (before 2018), RMB used to trade in the range of 20 to 25x forward PE. I expect the market to re-rate the business back to that range (at 22x forward PE) once everything normalizes in FY24.

Risks

My main concern continues to revolve around RMD's expanding market presence in the absence of Philips Respironics as a competitor . The key issue here lies in the fact that Philips is not a small or emerging player in the market. They possess the financial resources for research and development and have a strong financial position that enables them to potentially reintroduce a new product, likely at RMD's expense, to regain their lost market share. While RMD benefit from its robust product offerings and support from referring physicians, which supports its ability to retain gained market share, the potential for irrational competition from Philips, including aggressive price reductions, could unquestionably impact RMD's market share standing.

Summary

I recommend a buy rating for RMD based on my expectation that the market will re-evaluate the stock and return it to its historical average once normal conditions prevail. Factors such as gross margin recovery over time, balanced inventory levels, and improving freight costs should contribute to this re-evaluation. While short-term gross margins face challenges, I view this as a temporary setback. My valuation model suggests a target price of $177 in FY24, representing a 20% increase, taking into account a growth slowdown, competition from Philips, and the normalization of mask sales. I anticipate the market will re-rate RMD to a forward PE range of 20-25x, specifically at 22x, once conditions normalize in FY24. However, my main concern revolves around Philips potentially re-entering the market and challenging RMD's market share. While RMD has strong product offerings and physician support, Philips' competitive tactics, including aggressive pricing, could impact RMD's market standing.

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