Is ResMed Sell-Off Overdone?

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

-Concerns over mask sales
-Countered by strong FG sales
-Still taking market share
-Global environment stable
 

By Eva Brocklehurst

ResMed ((RMD)) disappointed the market with its March quarter results when it came to masks. Countering this weakness was strong growth in flow generator sales. The company also downgraded June quarter margin guidance to 59-60% from 60-62%.

The miss to forecasts was largely as a result of weakness in gross margins and currency movements, which JP Morgan expects to reverse in 3-6 months. The broker found the downgrade to margin guidance a little unnerving but believes it can be easily explained by FX movements and an adverse shift in the mix of sales. The latter is more than likely temporary because of the unprecedented demand for the lower-margin flow generators in the quarter. The main offset to the weakness was what JP Morgan describes as an extraordinary validation of the company's latest flow generator platform, a 42% growth rate in the US. Globally, flow generator sales rose 26%.

Momentum is building as recent launches of Aircurve and Astral products ramp up and, in JP Morgan's view, especially if the Serve HF data is as compelling as it sounds for ventilator use amongst cardio/respiratory patients. The broker believes the value proposition of the Airsense-10 (AS10) is resonating with the durable medical equipment channel and this should generate similar US growth in the June quarter.

Management explained the lacklustre mask growth as the impact of a re-basing of prices, which has taken longer than expected. JP Morgan suspects this stems from further discounting by peers. While ventilators have the potential to more than offset the weakness in masks, a rebound is still required in that market for further upside to the group's earnings outlook. JP Morgan retains an Overweight rating and raises the target to $9.70 from $7.71.

Macquarie considers the market typically places high value on the flow generator sales because these are the best measure of the rate of new diagnoses and a leading indicator for mask sales, as newly diagnosed patients begin using and replacing masks. However, the broker suspects the usual dynamics may not be in play this quarter. There is no doubt ResMed has gained share in flow generators but the broker argues this is likely emanating from a large increase in upgrades to the AS10. Upgrades would be the reason why there is a lack of flow-on benefit for mask sales.

Macquarie suspects these upgrade sales will fade next year and turn into a headwind for earnings growth. The broker has lingering concerns about sluggish growth in masks and whether this can be turned around. Hence, a ratings downgrade to Neutral from Outperform with a target of $9.00.

The market should be cautious about over-interpreting the March quarter results, in the opinion of UBS. Distortions in the quarter are typically reversed in the June quarter. Likewise, US flow generator comparables are encouraging and should support a more positive interpretation of the outlook. The broker normalises estimates for "channel stuffing" and partial price reductions which occurred in the prior March quarter and calculates that underlying mask growth may have been 7-8%, instead of the 4.0% contraction in the headline numbers.

Furthermore, given the size of flow generator growth in the quarter, UBS maintains AS10 has captured momentum not seen since FY06 and, with a staged roll out and positive signals, this could persist at higher levels and beyond the 12-month cycle that the market is currently estimating. That said, while believing the headline numbers for masks understate underlying growth, the broker acknowledges there is no near-term strategy that promises higher growth. Ideally, ResMed should be able to improve the ratio of flow generators fitted with its own masks.

Morgans is also confident of the longer-term earnings profile, given the early stage in the product cycle. The softer gross margin disappointed the broker but this is expected to stabilise on the back of a weaker Australian dollar, optimisation of product mix and cost cutting programs. Global pricing and regulatory environments are stable and the company continues to take market share in the sleep disorder segment. The share price sell-off is overdone and a buying opportunity in Morgans' view, while trading levels are undemanding.

Industry feedback suggests to Deutsche Bank that the Air devices are a superior offering. Nevertheless, the inability to leverage a dominant position into mask sales is of concern to this broker, especially given the impact on margins. Deutsche Bank is optimistic ResMed will be able to rebuild its position with masks but now expects the weighting of sales to devices will be larger. This results in a sharp cut to the broker's gross margin forecasts, which is only partly offset by improving cost leverage. Morgan Stanley does not envisage a recovery in mask sales until the first quarter of FY16. The stock looks fully valued. Hence, the broker maintains an Equal-weight rating on an industry-relative basis.

Credit Suisse, on the other hand, believes the result was actually better than the headlines suggest. While reducing earnings estimates by 2-9% across forecasts, because of re-basing in mask sales, gross margin and share repurchases, the broker maintains an Outperform rating but reduce its target to $9.80 from $10.70. Mask growth should recover, along with gross margins, over FY16 as the product mix reverts to more normal levels and cost cutting is achieved, in Credit Suisse's view.

While stabilisation of market share in masks is necessary to support the current valuation the broker believes the company's' strategy in growing a larger installed base of customers should deliver recurring revenue benefits.

On FNArena's database there are five Buy ratings and three Hold. The consensus target is $10.05, which suggests 18.5% upside to the last share price. 
 

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