Is Resmed a stock pick?

Is Resmed a stock pick?

Resmed recently released its results for the September quarter – the first period to fully reflect the significantly lower reimbursement rates independent distributors of Resmed’s products receive from Medicare in the US. While this disruption in the market was anticipated and widely known, the fall in Resmed’s sales was greater than expected.

The question to ask however is: is the issue permanent or merely a temporary one that is being treated as permanent by a bi-polar Mr Market?

Resmed is the global leader in the production of flow generators and masks for sufferers of sleep apnoea. The company has achieved annual sales growth of over 10 per cent for the past decade, but only grew sales by an annualised 5 per cent in the latest quarter.

As a part of the US government’s cost saving drive, Medicare now asks medical device distributors to tender for the right to supply specific products and volumes in defined regions. The new system is working. Medicare is now paying lower prices including those for flow generators because it has transpired that all of the distributors have been undercutting each other in their tendering.

But while Medicare reduced reimbursement rates to distributors by 47 per cent on 1 July, this segment only comprises 10 per cent of Resmed’s sales. The impact on Resmed’s sales growth was therefore not expected to be so severe. Perhaps less surprising and far more predictable however was the share price reaction, which subsequently fell by 10 per cent.

After examining the result, it appears that Resmed’s sales have been only temporarily affected by the changes in the industry. A 47 per cent reduction in Medicare reimbursement rates to distributors indicates that they bid too aggressively on contracts to distribute flow generators, and upon this realisation, a period of introspection has ensued. It also appears that many of the incumbents who have failed to compete at this new price point have been slow to hand over their customer lists to the winners.

The fact that Resmed was able to maintain such strong margins during the period however indicates that volume was the driving factor behind the fall in sales, rather than pricing pressure. On balance, it seems that first quarter’s decline in sales is temporary, but there are a number of factors of which we are mindful that could be structural.

The first consideration is increasing competitive pressure from Respironics and Fisher & Paykel. The fact that Resmed grew mask sales by only 3 per cent in the US during the quarter suggests these competitors appear to be taking share. At the end of the first quarter, however, Resmed launched a new range of masks that is expected to contribute materially to second quarter results.

The second consideration is further price deflation as a result of the cuts to reimbursement rates. Prior to competitive bidding, Resmed estimated that global price deflation in the industry was between 3 and 5 per cent. When competitive bidding was announced, management estimated that price deflation would increase to 4 to 6 per cent. Yet in the latest quarterly results, management noted that price deflation during this period was 5 to 7 per cent. Should we be concerned that the actual impact has been larger than management anticipated? In business can you ever be so precise?

Resmed has historically been able to charge a premium on its products due to their superior quality. Given that the company dedicates 8 per cent of its sales to research and development, it is unlikely that this quality will deteriorate. But Resmed may be forced to absorb further price reductions if the distributors are unable to remain profitable in the new reimbursement environment.

Despite these concerns, we still consider Resmed to be a compelling investment with a number of levers at its disposal to navigate this market disruption. Firstly, the company maintained its impressive margins during the first quarter, which can further improve as the company shifts production to Singapore. Secondly, Resmed’s technology has the potential to benefit sufferers of cardiovascular disease, which may provide access to a new market; and finally, Resmed’s machines have superior data collection technology, which can provide valuable information to distributors to monitor user compliance. This latter point is extremely valuable because the distributors will only be fully reimbursed by Medicare if the end user employs the products appropriately and for a pre-defined time.

At Montgomery, we continue to own Resmed and currently we believe the market has overreacted to the latest developments, which appear to be temporary in terms of their impact. Of course at any time our views could change so be sure to seek personal and professional financial advice.