Why I Believe the Market Got It Wrong About $RMD

$RMD has followed NYSE down another 5% on the open, which indicates there has been a pause for thought over the weekend (given that NYSE plummeted 18.5%).

I have picked up a parcel at $29.00, and stand poised for another, should we see the price drop to $28.50. Usually, I've learned not to catch a falling knife, but I'll make an exception for $RMD and in this note I set out why.

I have updated my valuations over the weekend, and nudged my expected value down from $37.00 to $35.10 - in truth, I could believe anything from $34 - $40, and Friday's result didn't really change that.

Some of what I cover in this straw has been discussed by other Straw People and me over the weekend. However, in this straw I go into a little more depth.

How did the market respond to $RMD results?

$RMD reported their 4Q results after NYSE closed and prior to ASX opening on Friday 3rd.

Shares are dual-listed on the NYSE, which every 1 US Common Stock trading as 10 CDIs on the ASX.

ASX 3rd August: $RMD opened at $30.10, down 11% from their Thursday ASX close of $33.85, closing the day at $30.70, down 9.31%. Volumes were high, with 14M shares traded, up on the more typical 1M. The 14M CDIs, traded are equivalent to 1.4M US Common Stock.

NYSE 3rd August: In New York, with more time to sharpen their pencils, the sell-off continued. 5.8m stock trading through the day – again around ten times typical daily volumes. New York closed at $179.25, down 18.5% (ouch!!)

The New York price, at an FX of 0.657 is equivalent to a Monday opening price of $27.28.

So all things being equal, $RMD should open around $27.28. (It didn't, it opened at $28.87, a cumulative fall since the 2nd August of 15%)

(To compare the prices on NYSE and ASX, you need to calculate: P(ASX) = P(NYSE) /10 / USD:AUD). Apologies if that is obvious to everyone, but I thought it might be helpful to explain.

Why did the market respond in this way?

In short, the result was a 5% eps miss. Market consensus was for eps of $1.69 per share, and the result came in at $1.60 per share.

While revenues grew strongly, (up 23% for the Q and 18% for the Y), analysts focused on the reduction in %GM which contracted 210 bps to 55.0% for the Q to pcp, and by 80bps to 55.8% for the Y to pcp. (Some - a small part - of this was FX)

How have valuations and targets been updated?

Using the data on marketscreener.com, and based on 6 of 12 brokers submitting target prices, after 6 have down graded the predictions on price targets have moved as follows (min, mean, max)

Pre-results:       US$ ($221.00, $259.79, $290.00)    estimated A$ ($33.63, $39.54, $44.14)

Post-results:      US$ ($207.00, $248.63, $284.00)   estimated A$ ($31.51, $37.84, $43.22)

So, the average decline is only 4.3%. However, only 50% of the dataset has updated, and usually when there are both upwards and downwards revisions, further updates follow during the next few days and even weeks. Part of the reason for this, is that the CEO and CFO will usually do a roadshow with major shareholders and institutions, and some will hold off updating their research until these conversations have taken place. In the forthcoming roadshow, the discussions will – I imagine – dig into some of the statements made on the call on the outlook for margins. In particular, remarks by Mick Farrell that high cost inventory is yet to work through fully. They’ll also dig into the impact of product mix on gross margin. Devices are lowest margin, with masks, consumables (filters, hoses etc.) on a significantly higher margin, and SaaS obviously much higher, but a small component.

The only detailed note I have is that of Goldman Sachs (Chris Cooper), an $RMD bull, who downgraded their 12m PT by 3% from A$39.60 to A$38.40, offering a detailed analysis in support.

So basically, the soft result has taken the analysts more or less back to where they were in July 2022, when everyone started getting bullish about $RMD again.

The figure below shows the consensus evolution from marketscreener.com.

Source: www.marketscreener.com

Why do I believe the market in NY and - as a consequence - the ASX on open has over-reacted?

We covered a lot of this in the usual excellent SM discussion over the week-end, so here I will summarise supported by a few data-driven charts, but I will add my own commentary resulting from the deep dive conducted during the weekend. (Yes, it was rainy in Brisbane!)

First of all, the overall result was very strong. Figure 1 illustrates.

Figure 1: Sales, Operating Profit and Net Income

Source: Company Accounts

I have plotted the revenue growth trend from 2018-2022, which shows clearly that $RMD drove sales hard in FY23. Let’s remember what happened and understand what has been going on. Understanding this is important to believing that gross margins will be restored again over time.

First, in June 2021, Phillips had their product recall, which immediately resulted in 5 million devices being removed from the market. They’ve been absent from much of the market ever since.

But this recall happened just as the supply chain constraints and, in particular, the chip constraints were starting to bite. While everyone drew down inventory to supply the shortfall, no-one could supply at the rate required. ($FPH have separately reported the challenges they face.)

The types of chips in short supply in these devices are the same technology that are used across a range of industries, like the auto industry, white goods, televisions, audio equipment etc. Not the bleeding edge high-performing chips you find in gaming PCs and laptops. It is these “lower tech” chips that really hit the crunch. As a result, manufacturers, like RMD, re-engineered their existing devices. Air Sense 10 was reconfigured to download data to an SD card, which required fewer electronics than the direct to cloud models.

These efforts allowed RMD to continue to supply the market, but they were unable to fully meet the opportunity presented by the withdrawal of Phillips. Of course, what also “helped” was that the closure of sleep clinics during COVID-19, did constrain the flow of new diagnoses. But of course, these have now opened up again.

Roll forward to FY23, and with supply chains repaired and Phillips still out of the market, sleep clinics open again, $RMD was able to achieve bumper sales. We won't see another +18% sales ... not ever!

In Figure 1, you can see that sales were approximately $400m above where they would have been on the 5-year trend.

But that incremental $400m is largely CPAP machines, and these devices have lower margins than the masks, hoses, and accessories.

Despite the degradation in % gross margin, overall operating profit has stayed largely on its 5-year trend. The CAGR in EBIT from 2018 to 2022 was 15.6%, and FY22 to FY23 was up 22.4%. Not too shabby, and not a result justifying a 15% SP fall..

Let’s now look at margin evolution in Figure 2.

 Figure 2: Margin Evolution 2018 to 2023

First of all, what the market is so concerned about, %GM (the top blue line). If we look at pre-COVID being FY18 - FY20 (only 3 months COVID impacted and pre-Phillips), GM averaged 58.4% - which I will take as the baseline, as it has historically moved around a bit driven by product mix and FX.

Certainly, the trend from 58.4% to the 55.0% in Q4 FY23 is a worrying trend,… if it continues. And Mile Farrell was clear that it won’t. However, perhaps the market doesn’t believe him. At Q3 Results call he said:

“I see gross margin expansion in double-digit basis points ahead for the coming quarters and throughout the fiscal year and the calendar year. I'm bullish on gross margin expansion because I see geography mix and product mix headwinds subsiding. I'm bullish on gross margin as I see ventilator growth opportunities start to come back, and I see mask growth and replenishment growth, new patient growth start to come on masks. And I'm bullish on gross margin as we go forward because I see inventory costs starting to -- we're going to start to cut into that and bring them down versus the run-up we had with our competitor being out of market.”

Ninety days comes around quickly, but we didn’t see any of this in the results. In fact, %GM continued to slide from 55.3% to 55.0%. However, Mick restated his conviction that %GM would improve in the Q$ results call – while not actually confronting the fact he’d got it wrong (even though he was pushed by one analyst in the Q&A).

But I believe that – now they have the supply - $RMD has been going all out for share. Making hay while the Phillips-Sun shine. The gross profit and strong operating cashflow shows that was a rational thing to do, even though it means there %GM will be under the microscope in Q1 FY24.

Before leaving the margin picture, it is worth highlighting the strong picture shown by net margin. Over the last 5 years, $RMD appears to be gradually ratcheting up its overall economies of scale, going from a mid-teens net margin to a low-20% net margin.

You can also see the grey line, FCF % margin. This has been volatile due to movements in inventory and lumpiness in tax payments. More on inventory next.

For the final chart, we can consider some of the key revenue ratios shown in Figure 3.

Figure 3: $RMD Revenue Ratios (2018-2023)

Source: Company Accounts

We’ve already discussed the problem-child of %GM. Looking forward, I expect this to gradually start trending back up. Although it might not recover the halcyon days of 59.0%, it is reasonable to expect it to trend back to 57% over the next 1-to-2 years. This is because the turmoil and expediting arrangements required for the last few years, will be able to be optimised. Once AirSense-11 production fully ramps up, these manufacturing and supply arrangements will also move onto more of a steady state. Finally, inventory levels will move to more of a steady-state model. There will also be benefits on chips, as a cooling global economy and reinvestment in supply could even lead to over-supply.

True, Phillips will return, and this may increase competitive pressure on margins. But, as Mick points out, there are already several other competitors in the market ($FPH being one!). And Phillips will be starting again from at least a number 4 position in many markets.

The orange SG&A line shows how increasing economies of scale have allowed overheads to scale slower than revenue growth. Of course, FY21 and FY22 were helped by significant reductions in travel, and Mick explained that FY23’s slight uptick was due to both staffing costs and travel. Guidance for FY24 of 20-22% for SG&A allows some further headroom.

R&D has consistently been held at 6-7%, and Mick has guided for FY24 to be 7-8%. Ongoing investment in R&D is a good thing, as $RMD need to continue to reinvest to maintain its industry leadership, particularly as it strives to add further value by exploiting the huge dataset captured from customers.

I finish with Figure 3 by pointing to inventory (black line). You can see that inventory has reached 23.6% of elevated sales – a dramatic increase from historical norms of 13-15%.

Over time, $RMD should be able to manage levels back to historical norms. That said, across the board companies are reviewing their supply chain strategies, and it is to be expected that one of the lessons from the pandemic is that firms will place a greater emphasis on supply chain resilience over efficiency. So perhaps for $RMD, we will see inventory settle somewhat higher than has historically been the case.

[I admit here to being a bit of a supply chain geek, and in my spare time I teach operations and supply chain management to MBAs. I am thinking about using companies like $RMD as future teaching case studies, I already use $BRG.]

Looking Forward

$RMD continues to innovate. Mick spoke about him personally trialling the next generation of mask, due out later in FY24.

A key asset will be the huge dataset from customers that it continues to build. This will give it unparalleled insights not only into improving and innovating its own products and services, but also in identifying new therapies and positioning itself (e.g., via acquisitions) to offer these in the long term. Because of this, I have no hesitation in seeing $RMD continuing to grow revenue at 10%-14% p.a., for the foreseeable future. After all it has done a CAGR over the last 4 years of 11.2%, and last year revenue growth was 18%. I am also therefore happy to assume continuing value free cash flow growth of 5% p.a. beyond the 10-year horizon.

But before I get too excited based on a largely backward-looking analysis, what are the major risks?

1. New Therapies: As discussed elsewhere on SM, several new therapies are emerging to tackle weight loss. Obesity - particularly in developed countries - is one of the big drivers of sleep apnoea. This is something to keep an eye on over time. But I am convinced that this is a longer-term, generational consideration, and not an issue impacting my investing time horizon of 5-10 years. The rationale is as follows:

• Sleep apnoea is under-diagnosed and under-treated; the global market is vast. Although $RMD currently treats 160m patients globally, its near-term target is to reach 250m and it estimates the potential total market at around 1bn.
• $RMD devices have application beyond sleep apnoea, including COPD (also underdiagnosed, and growing strongly) and some cardiac conditions. There are even instances when it can be helpful in asthma. There is growing clinical evidence of the effectiveness and economic benefits of CPAP, APAP, and related therapies. The cloud monitoring adds to the toolkit that incrementally allows patients to be trreated in the home.
• $RMD has the market leading position, helped by the withdrawal of Phillips for what will be 2 to 3 years by the time Phillips returns later this year. Both $RMD and competitors have filled the gap in the market place, and while the return of Phillips will increase competition, it will not be a game-changer, as the market is already competitive. One investment bank has estimated that $RMD has driven its markets share from 47% in 2019 to over 60%.
• Drugs are emerging and growing in use; however, they are expensive. The lifetime cost of the current GLP-1 treatments is c. $480,000, which $RMD estimates to be 35x the cost of the CPAP. Adherence to drug treatments is low at the 1-year mark, compared with >80% cited for CPAP, and the new drug treatments - though reasonably well-tolerated – have a wide range of side effects from lower risk higher prevalence to some rare/severe conditions. CPAC’s primary issue is some discomfort and facial marks from the masks.

2. Product Recall: Of course, Phillips has shown what a devasting impact a product recall can have. And, hopefully, $RMD have learned lessons and will be unrelenting in their pursuit of quality. While no-one can ever rule out such a shock befalling the company, I prefer to accept this risk through constraining my position size to 6.0% rather than in a valuation scenario, where I cannot assign a reasonable probability.

My Key Takeaway

There is nothing in $RMD’s performance that causes me to doubt the basis of my updated $35 valuation. And when considering various scenarios around that value, a SP below $30 offers a very highly skewed risk-reward profile to the upside.

If there is one surprise, it is that Mick was premature in predicting the GM% improvement. That is uncharacteristic of him. But as their supply chain pressures eased, perhaps the pent-up demand, the gross profit and market share opportunity was just too tempting. In any event, SP has paid a heavy -15% price for that error. And I contend the correction is a gross over-reaction.

Quality companies regularly present pullbacks. Those are the days I buy them. Today is one of those days. I've taken a small bite at $29.00, and have another order in at $28.00, if Mr/(s) Market will oblige me (which I doubt (s)/he will).

Disc: Held in RL (I don't hold companies that have proven to be long-term wealth winners on SM)