ResMed (ASX:RMD) shares have underperformed the broader market this calendar year, as COVID-related supply constraints have impacted revenue and margins. We recently researched the Company to assess the extent and timing of any improvement and accordingly, whether the current weakness in the shares presents an attractive opportunity.
About ResMed
ResMed provides products for the treatment of sleep-related breathing disorders, including sleep apnea, Chronic Obstructive Pulmonary Disease (COPD), and other respiratory conditions. The product portfolio has traditionally included airflow generators, nasal masks and pillows that introduce airflow. In recent years it hasexpanded to offer digital solutions. The Company now has three reporting lines by product: Masks, Devices and Software-as-a-Solution (SaaS).
Key Fundamental Drivers
Revenue Trends Expected to Improve
A key positive from the recently-announced results for the 2nd quarter of financial year 2022 (2Q22) was strong US devices growth at ~19% and Rest of World (RoW) devices growth at 13%. This is despite supply chain challenges and a lower-than-expected benefit from the Philips product recall.
Whilst mask sales were ahead of market expectations, overall new patient starts have been impacted due to the Philips recall. This provides an overall market headwind for mask/accessories. Despite the impact from the Philips recall, new patient flow has improved and now sit at 85-100% of pre-COVID-19 levels, with some locations >100%.
However, momentum in the accretive masks category has been impacted by the loss of cumulative diagnoses through the period. It may take some time before mask growth returns towards the 3-year quarterly average of +14% that the market had become increasingly accustomed to. With COVID-19 cases now declining rapidly in most key markets, and hospital conditions continuing to normalise, continued sequential improvements in new patient starts are expected.
Impact From Near-Term Supply Constraints to Eventually Reverse
At the 2Q22 results release, the Company referred to ongoing “unprecedented dislocation” in the supply chain. For example, logistical, higher raw materials, and scarce electronic components. This is resulting in limited output and prioritising product allocation.
RMD highlighted electronic component shortages and freight constraints, which are currently limiting output and incremental device revenue associated with the Philips product recall. At the 2Q22 result, the Company reported an estimated US$45-55m in incremental device revenue. This represented a sharp sequential slowdown from US$80-90m in 1Q22. The Company reiterated previous guidance of US$300-350m in incremental device revenue in FY22, with expectations for more substantial contributions in 4Q22 and into FY23.
Freight costs are an additional headwind that is expected to remain over coming quarters. However, supply constraints are anticipated to ease by 4Q22 and into FY23, reflecting an expectation of improved component availability as well as a re-engineering of supply chains (i.e. allowing the use of new suppliers). The implication here is that there is scope for increased new patient diagnoses once supply chain issues abate (or the supply of devices increases).
Philips aims to complete its repair/replace program by 4Q22 and while there are clearly various risks around the remaining execution of the program, any extension or additional complexity of surrounding Philips’ program provides RMD with an opportunity to further enhance its competitive opportunity/gain market share.
The Company is also undertaking a number of internal measures to address supply constraints. These include securing longer-term supply commitments, increased the portion of spot buying, chartered flights to bypass freight congestion and adjusted product design.
Potential for Recovery in Gross Profit Margin
A key negative from the 2Q22 result was the contraction in gross profit margin from 59.9% in 2Q21 to 57.6% in 2Q22. This was a result of higher freight costs, higher supply chain costs, and elevated component pricing. The impact on gross profit margin was partially offset by favourable product mix toward higher acuity devices.
While the Company provided no guidance on gross profit margin, it is likely to remain suppressed due to the above-mentioned factors that impacted in 2Q22. Having said that, there is upside potential to margins (both gross profit and operating) from pricing power, as well as RMD having successfully passed through a reasonable proportion of these costs to the consumer as freight surcharges since the start of this calendar year – largely reflecting the increasing strength of RMD’s competitive position.
Further, the recently-launched AirSense 11 device is supporting a multi-period benefit to average selling prices. AirSense 11, which is priced higher than AirSense 10, has also driven increased uptake of myAir. A peer-reviewed study of >85,000 patients indicated the use of myAir software in conjunction with the AirSense platform provide adherence rates of >87% to Positive Airway Pressure (PAP) therapy.
Fundamental View
RMD shares are currently trading below its average P/E multiple over the last two years and we consider that there are several factors underpinning the potential for RMD to eventually regain its premium rating:
i. Philip’s product recall, along with the launch of the new AirSense 11 device platform and a continued sequential improvement in new patient starts, should support a strong lift in revenue in FY22 and FY23,
ii. A potentially protracted Philips recall places the Company in a position to strengthen its market share,
iii. There is potential for a faster-than-expected recovery margins (both gross profit and operating),
iv. Pricing power is evident and is likely to strengthen as current freight and other cost challenges abate, and
v. A strengthened balance sheet (with a net cash position expected in FY22/23) increases the potential for capital management and/or acquisitions.
Charting View
RMD shares continue to look weak on the chart, which means that investors can look to pick it up at cheaper levels. After falling away in September – October, it managed to find support near $34 and it then started to edge higher. Then in early January, it broke support, came back up to retest the underneath of it, and then fell away again. Risk is still to the downside for now and we would be looking for support to come back in somewhere between $28 and $30.
Michael Gable is managing director of Fairmont Equities.
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