2023-10-27 23:25:41 ET
Summary
- ResMed's share price has fallen by over 40% since highs hit in April 2023.
- GLP-1 weight-loss drugs are expected to reduce demand for ResMed's products that treat obstructive sleep apnea.
- FY23 operating conditions were very favourable for ResMed and revenue growth has slowed materially.
- Investors should be mindful of downside risks, but valuation support warrants a Buy rating.
Introduction
ResMed Inc. ( RMD ) reported 1Q24 results after market on 26 October 2023. In this note I’ll review the 1Q24 materials and discuss new positive and negative factors that are relevant to the RMD investment case. With RMD currently trading at ~$136 per share, the stock has fallen by ~44% since late April 2023. I’m on the lookout for a healthcare stock to add to my portfolio, so I’ll review RMD’s valuation and see if the price fall has opened up an opportunity to buy a company that has a solid growth track record at a reasonable multiple.
1Q24 Positives
Key positives reported in the 1Q24 materials are summarized and discussed below:
- The group Non-GAAP gross margin improved slightly from 55.8% in 4Q23 to 56.0% in 1Q24. However, relative to 1Q23, the Non-GAAP gross margin has declined (from 57.6%). Note that the 1Q24 Non-GAAP gross margin excludes costs relating to a field safety notification on Astral devices .
- RMD report that new patient starts on Airview (the group’s physician/provider-facing platform) and myAir (RMD’s patient-facing app) were very strong.
- As per slide 12 of the results presentation , RMD expects to resume share buybacks in 2Q24.
1Q24 Negatives
Key negatives reported in the 1Q24 materials are summarized and discussed below:
- After six consecutive quarters of revenue growth for Devices in USA, Canada and Latin America, this segment’s revenue fell by -10.7% in 1Q24 (relative to 4Q23). Quarterly revenue for Devices can be quite volatile, but the 1Q24 outcome appears to be rather soft.
- Software-as-a-Service (‘SaaS’) revenue is up +31.5% versus 1Q23, but was up by a very modest 0.5% relative to 4Q23. Note however that 1Q23 excluded any contribution from MEDIFOX DAN, which was acquired in November 2022. After jumping by 17.1% in 2Q33 (relative to 1Q23) with MEDIFOX DAN coming fully on stream, SaaS revenue has grown by only 1.8% in the last 6 months.
- Revenue for Devices, Masks and Other in Europe/Asia/Other is up +22% versus 1Q23, however quarterly revenue for this segment was only up by +0.6% versus 4Q23, and down by -7.5% relative to a strong 3Q23.
Demand Threat From GLP-1 Weight-Loss Drugs
Relative to many other companies, RMD’s presentation packs are fairly light on detail. The addition of a new slide at 1Q24 looking at the potential impact of GLP-1 weight-loss drugs on obstructive sleep apnea (‘OSA’) prevalence points to management feeling that they need to address an issue that the market is obviously worried about. The backdrop of a large and under-penetrated addressable market for OSA treatments has been a consistent feature of the investment case for RMD for many years, and a material change to this backdrop has obvious consequence for expectations regarding RMD’s future earnings growth profile.
In the 4Q23 analyst Q&A session, CEO Michael Farrell played down the risk to RMD from GLP-1 weight loss drugs. Extracts from the CEO’s 4Q23 comments are shown below. I found the CEO’s comments rather dismissive regarding the GLP-1 risks, and somewhat unbalanced (for example, there’s no mention of the side-effects of RMD's CPAP machines – in fact Farrell even made a joke about the supposed lack of side effects). CEO’s come in all shapes and sizes, but Farrell strikes me as one who is not afraid to go heavy on the positive spin.
I was just reading in the press today that many U.S. employers are banning coverage of GLP-1s due to cost. European governments have all said, no, from the government insurance side. These things are incredibly expensive, about $1,000 -- well, it's anywhere from $800 to $1,200, $1,000 a month. So I think there are 3 factors that will mitigate GLPs in the space. One is cost. Two is adherence, and three is side effects.
If you look at cost, take a 40-year-old person who's on therapy, full-time, for 40 years, 40 x 12 x $1,000 is $480,000 lifetime cost for that patient on a GLP-1 from 40 to 80 lifetime cost. If you take that same patient and say, well, let's treat them with CPAP, right? First year, maybe $1,000 and then 39 years of -- let's take a really strong case where you get 4 masks a year, and they're all full face masks. That's $13,500. So it's 35x more expensive to go with the GLP-1.
On adherence, the data out there -- about 33% adherence at 1 year through the clinical trials on GLP-1s. That's incredibly low. We get 87% adherence in 90 days, and we hold it pretty strong there.
And third is side effects, reading thyroid, pancreas, kidney, cancer, these major side effects and minor ones like nausea, constipation and pain. Our biggest side effect as President Biden had a little mark on his face, and he was asked about it and it was from his CPAP.
Look, I think it's a long road to play out here. I think it's frankly good marketing around the area of obesity, and it can drive patients into the funnel. But I don't think it's going to be a major impact on patients because we've got 936 million of them worldwide, and we need them to get into the funnel. If they come in the funnel because they tried a pill and it didn't work, that's good for us, too.
Source: RMD 4Q23 Transcript , pages 8 and 9.
Given the CEO’s previous comments above, I was slightly surprised to see the chart shown in Exhibit 1. The natural conclusion is that RMD see concerns regarding GLP-1 related risks as a driver of the stock’s recent share price decline, and that the market needs to be put straight. I have a number of issues with Exhibit 1, which are discussed below. Bulls on RMD may take a lot of comfort from this chart, but I’m rather underwhelmed and I think it should be taken with a healthy dose of salt.
Exhibit 1:
Issues for investors to be aware of regarding Exhibit 1:
- Timeframe – in my view, projections out beyond 10 years are very uncertain. The range of outcomes by 2050 is logically very wide, however the chart as presented (with mostly straight lines) paints a picture of a stability/predictability.
- High pharma impact - footnote 3 to the chart states: ‘High impact of ~15% OSA prevalence reduction due to weight-loss pharma, with impact starting in 2024 and ramping by 2029.’ What confidence can we have that the GLP-1 related prevalence will be limited to 15%, and is it realistic that it reaches 15% and then flat-lines? I find this assumption to be over-simplistic. I expect that GLP-1 drugs will continue to improve over time, and I question whether such improvement has been factored in to the (grey line) projections.
- Turning to the important red line – RMD’s connected devices. Footnote 4 states: ‘Historical growth in ResMed connected device volumes ranges from 5-6% YOY; Growth here shown as 6%.’ RMD has used the upper end of its historical growth profile to project forward. A more conservative management team would have opted for the mid-point of the range, or even the lower end. When compounding over 26 years, what appears to be a small difference in annual growth rates make a lot of difference.
GLP-1 weight-loss drugs are not the only demand downside risk that investors should be aware of and that could cause actual outcomes for OSA patient numbers to trend very differently than the scenario shown by RMD in Exhibit 1. Apnimed is a small, unlisted biotech aiming to develop a safe and effective medication that addresses the underlying biology of OSA; the company has a drug (AD109) that is currently in FDA Phase 3 trials. I am not fully up to speed on the likelihood and timing of AD109 receiving FDA approval, or the potential addressable market for the new drug, but this appears to me to be another material demand downside risk factor for RMD’s core business.
Valuation Assessment
My preferred method for company valuation is to focus on the level of sustainable earnings that a business is currently generating. In doing so, I generally start with the company’s earnings over the last twelve months, and make normalization adjustments for factors that can be considered unsustainable or ‘one-off’ in nature. Typically, I will also make adjustments for accounting items that a company includes in earnings that I consider to be ‘non-cash’.
RMD management report an adjusted earnings measure referred to as ‘Non-GAAP Operating Income’; the adjustments made by RMD to arrive at Non-GAAP Operating Income mostly appear fair and reasonable to me and I therefore use this earnings metric as the base for my valuation assessment. However, in the case of the 1Q24 Astral field safety notification expenses (-$7.911m), which management excludes from Non-GAAP Operating Income, I allow for 25% of these expenses in my normalization adjustment (to reflect that my view similar events and associated costs can be expected to repeat occasionally over time).
Exhibit 2 shows RMD’s implied 1-year forward EV/EBIT multiple based on the current share price of ~$136 per share. The Base Case allows for earnings growth over the next year of 3%. The Bull Case assumes 8% earnings growth over the next year. It can be argued that the Base Case is too conservative given RMD’s impressive history of earnings growth. However, it should be remembered that, thanks to the ongoing problems at Philips Respironics , RMD has enjoyed the absence of a key competitor in the OSA/respiratory care market. In deliberately using a ‘low’ earnings growth assumption of 3%, my Base Case valuation is making an allowance for the fact that RMD has been over-earning in recent quarters and that this temporary boost to earnings will fade over time as competitive tension returns to the market.
Exhibit 2:
For a stock in the healthcare sector, I would typically regard an EV/EBIT multiple of ~20x as being around fair value. For a high-quality company, where I felt strong conviction about relatively high future earnings growth rates, I'd be willing to push the fair value benchmark up to ~25x.
In the case of RMD, taking a rear-view mirror approach, I am inclined to consider the company as pretty high-quality, despite some concerns regarding the group’s strategy to grow the SaaS segment, which diverts management focus away from OSA/respiratory care and introduces acquisition risk. Applying a more forward-looking mindset, I am conscious of the downside risks to RMD’s core business lines from GLP-1 weight-loss drugs and Apnimed’s AD109. On balance, as things stand today, given material medium-term risks to future revenue growth, I consider a fair value EV/EBIT multiple for RMD to be ~20x.
Summary & Conclusion
With a key competitor in the Americas out of action in FY23, RMD enjoyed extremely strong operating conditions. Whilst the market would not have assumed that FY23’s revenue growth of 25% for USA, Canada and Latin America was sustainable, the inevitable downward normalization of revenue growth has the potential to drive ongoing negative investor sentiment towards the stock. Longer-term threats to OSA-related demand for RMD’s devices and masks from GLP-1 weight-loss drugs and a potential medication that directly targets OSA (rather than obesity) are difficult to quantify, but have the potential to be materially negative in regard to RMD’s ability to continue to grow operating income.
As highlighted above, it is easy to identify a number of negative issues regarding the investment case for RMD. However, using a simple normalized earnings valuation approach - which points to RMD currently trading on a EV/EBIT multiple of ~16x - it is clear that a lot of negativity is being priced in by the market. Based primarily on valuation, I am willing to stick my neck out a little on RMD and give the stock a Buy rating (at ~$136 per share).
For further details see:
ResMed: Weight-Loss Drug Worries Provide Buying Opportunity