Why we see further upside for ResMed

In June this year, Philips was forced to recall 14 sleep and respiratory care devices due to safety concerns. While this has been a setback for the Dutch company, it’s been a major plus for Australia’s ResMed, which is poised to significantly boost its market share.

ResMed (ASX: RMD) is a company we have owned throughout the life of our funds. The quality of the company is extraordinary and the prospects for its major product, in the absence of a better ‘mouse trap,’ are excellent.

Indeed, this was demonstrated in the 5 August results briefing, in which the company noted: “At this time of incredible demand for ResMed products, we are doing everything we can to increase our manufacturing of sleep and respiratory care devices. Our global team is supporting patients, providers, and physicians with our priority to get products directly into the hands of patients who need therapy most.”

Growing demand for ResMed’s products received a further boost from the global Class 1 recall of its competitor Philips’s main product.

According to the US Food and Drug Administration, a Class 1 recall applies to a situation in which there is a reasonable probability that the use of, or exposure to, a violative product will cause serious adverse health consequences or death.

The Class 1 recall of the Philips product is extremely positive news for ResMed. Of course, the announcement and its positive implications are generally well known to us and the market and therefore reflected in a buoyant – some might say expensive – share price. More on that in a moment.

With the share price performing well, we have been content owners but we’ve also increased our stake recently. We’ve been conducting frequent calls with durable medical equipment (DME) distributors in the US and those calls have provided an insight into how grave the supply situation is. The distributors simply don’t have access to sufficient product volume and are having to ration supply, prioritising existing customers.

While we don’t have a complete picture of how distributors are dealing with customers who have in the past predominantly purchased Philips products, we do expect they will be amenable to a ResMed product if it is available before Philips restores supply. We also discovered ResMed’s new Airsense 11 product will be released sooner than anticipated in order to assist with the global shortage. It should also sell at a higher price point.

The combination of a revenue uplift at the same time that ResMed’s major competitor is completely absent from the market has material positive implications.

The potential opportunity for ResMed

It appears to us however the market might be underestimating the potential opportunity for ResMed. The current price appears to imply the Philips recall will deliver a 10% market share gain. And assuming 50% market share for ResMed, adding another 10% share provides 20% sales growth. While this more modest interpretation might reflect how the picture levels out over the medium to longer term, the short-term implications of the complete removal of a main competitor – one that commanded a 40 to 50% share of the market – are significantly more meaningful.

The opportunity for ResMed entirely depends on how much product ResMed has in inventory on the balance sheet and how quickly it can ramp up manufacturing, remembering they will sell every device they have.

This is not a situation where the sales are constrained by the size of the market. Subject to product availability, ResMed could experience a 70 to 80 per cent sales uplift and market share could feasibly increase from 50 to 80 per cent over the next six months. Philips needs to repair the existing product and replace all the devices in the market. In other words, every incremental sale is now going to ResMed.

Of course, one potential bottleneck to capturing the opportunity is the well-documented chip shortage, which has disrupted the supply for practically everything that plugs in. Our calls with competitors however suggest the chip shortage is not a material issue. Indeed, Philips themselves have said it’s not a material issue for them at this point in time.

Meanwhile, ResMed’s production capacity is increasing. In the last six months – in anticipation of the Airsense 11 launch – ResMed has commissioned a new plant in Singapore. People on the ground are telling us the plant presents a five-fold increase in footprint so manufacturing shouldn’t be a constraint.

The market is there for ResMed to win and it all comes down to parts and inventory.

The market anticipates 15-20% growth for ResMed’s revenue. How much of the sales uplift is sticky we can’t be sure but once a ventilator is sold, the mask sales generally adhere.

The historical Price Earnings multiple looks high but if the ‘E’ is wrong by 30%, value might be hiding in plain sight.

ResMed’s Fourth Quarter 2021 Highlights
(All comparisons are to the prior year period)

• Revenue increased by 14% to $876.1 million; up 10 per cent on a constant currency basis
• Gross margin of 56%; non-GAAP gross margin contracted 260 basis points to 57.3%
• Income from operations increased 8%; non-GAAP operating profit up 7%
• Diluted earnings per share of $1.33; non-GAAP diluted earnings per share of $1.35
• Quarterly dividend increased by 8% to $0.42 per share

ResMed’s Full Year 2021 Highlights
(All comparisons are to the prior year period)

• Revenue increased 8 per cent to $3.2 billion; up 6 per cent on a constant currency basis
• Gross margin of 57.5 per cent; non-GAAP gross margin contracted 70 basis points to 59.1 per cent
• Income from operations increased 12 per cent; non-GAAP operating profit up 12 per cent
• Diluted earnings per share of $3.24; non-GAAP diluted earnings per share of $5.33

Key quotes from Management:

“Our fourth quarter and full-year fiscal year 2021 results continue to demonstrate the strength and resiliency of our business,” said Mick Farrell, ResMed’s CEO.

“During the quarter, we saw the ongoing recovery of core sleep apnea and COPD patient flow across our business, as healthcare systems continue to adopt new models of patient care. We faced some headwinds this quarter, as we annualised the $125 million in COVID-related ventilator sales from this period in 2020, and we saw some tailwinds from a competitor’s major quality issue that was announced during the quarter. The net result was strong revenue growth of 10 per cent for our ResMed business in the June quarter. We finished the full fiscal year 2021 with 6 per cent revenue growth year-over-year to $3.2 billion, with operating profit up 12% on a non-GAAP basis.

“At this time of incredible demand for ResMed products, we are doing everything we can to increase our manufacturing of sleep and respiratory care devices. Our global team is supporting patients, providers, and physicians with our priority to get products directly into the hands of patients who need therapy most. Looking ahead, we are confident in our ability to grow steadily through our fiscal year 2022 and to deliver for all our stakeholders. We’re driving accelerated adoption of digital health solutions in sleep apnea, COPD, and out-of-hospital care, accelerating our ResMed 2025 strategy. These digital health solutions provide efficiency and lower costs for providers and payers, as well as better quality-of-life and clinical outcomes for patients and physicians, and sustainable growth for all of our ResMed stakeholders.”

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