ResMed (ASX:RMD) recently released results for the 2nd quarter of financial year 2019 (2Q19). The shares then fell more than 20 per cent in the space of two days. We analysed the company shortly after that in The Dynamic Investor. ResMed has since gained about a dollar since our report (to get in early next time, make sure you CLICK HERE and sign up to an 8-week trial of The Dynamic Investor). Do these levels represent a buying opportunity, or is the best now over for ResMed?
The Company provides products for the treatment of sleep-related breathing disorders. These include sleep apnea, chronic obstructive pulmonary disease, and other respiratory conditions. The product portfolio has traditionally included airflow generators, nasal masks and pillows that introduce airflow. The acquisition of Brightree in April 2016 expanded the Company’s operations to include the supply of business management software solutions to medical equipment and home health providers in the US.
Two Key Issues From Recent Results
Mixed Revenue Trends
Overall, the results were below market expectations, which initially led to a significant de-rating in the share price. One of the concerns emerging from the result was the mixed revenue growth performance in the Americas division, compared to the Rest of World (ROW) category.
Despite solid product sales growth in the key Americas division (+9% to US$358.5m), with a 7% increase in devices and 11% growth in masks, the group sales growth performance was considered below expectations. This was a result of a 4% decline in sales of flow generators in the ROW category, compared to the prior corresponding period (2Q18).
The ROW category includes Japan and France, which account for ~10% and ~5% of group revenue, respectively. During 2Q19, device sales in these countries were impacted as customers completed upgrades to the AirSense devices following positive reimbursement changes in FY18. By way of background, RMD’s FY18 sales into these two countries benefited from changes to CPAP reimbursement schedules as a result of existing CPAP users upgrading to cloud-connected devices. The Company expects these two geographies to be impacted throughout the remainder of FY19.
Gross Profit Margin Expansion Offset By Higher Guidance For Other Expenses
Higher gross profit margin in 2Q19 (historically a measure which is a key area of focus for investors) was overshadowed by increased guidance for both SG&A and R&D expenses (as a % of sales), higher net interest costs as a result of recent acquisitions, higher guidance for the effective tax rate and additional outside equity interest losses. The outlook commentary in relation to SG&A and R&D expense items, as well as net interest costs was slightly higher than both previous guidance and market expectations
Can the Shares Bounce Back?
From a high of $16.56 per share prior to the release of 2Q19 results, the share price has de-rated significantly. No doubt, the Company has strong fundamentals that underpin long-term value, in particular:
The potential for RMD to use data to improve at-home care, improve compliance, and increase the penetration rate within the sleep and COPD markets,
Recent acquisitions, while adding to the near-term cost base, have strategic long-term rationale,
RMD is growing market share in US devices and new masks gaining traction in the US and
A history of key cost items (SG&A and R&D) trending down over time – thus RMD achieving better leverage from improving gross profit margin.
Having said that, a re-rating back to recent highs appears unlikely over the short-term. The extent of the negative surprises arising from the 2Q19 results release (lower-than-expected device sales in ROW segment; higher expense guidance, slowdown of revenue growth from Brightree) have resulted in negative EPS revisions (in the order of ~5%) over FY19-21. These downgrades reflect a moderation in revenue growth assumptions (in particular, ROW device growth is the main driver of the lower revenue assumptions), the incorporation of higher cost guidance (as more investment is required to building out its SaaS platform) and losses from the Verily JV.
Further, RMD has invested heavily (US$1.5b) in its software-as-a-service (SaaS) offering and the slowdown of revenue growth from Brightree is causing some in the market to question the rationale for RMD’s investment in SaaS.
The market is also likely to remain cautious on the Company’s recent acquisitions and investment in the Verily JV (likely to remain loss-making) until there is more transparency in regards to the path to achieving profitability and a meaningful ROI (i.e. Verily is showing a higher-than-expected expense profile and Propeller Health requires higher cost investment).
A Charting View
When RMD got sold down a few weeks ago, it left a large bearish engulfing pattern (circled) on the weekly chart. Since then it has fallen towards trend-line support. That level also represented a 38.2% retracement of the 2016 – 2019 rally. So it now appears as though we have good price support for RMD. However, the severity of the recent sell-down means that the stock is unlikely to make much further progress in the short term. We may see it spend several weeks or so around these levels before it is ready to continue edging higher.
Michael Gable is managing director of Fairmont Equities.
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