ResMed’s Double-Digit Operating Leverage Is Offset By Valuation Risk (NYSE:RMD)

Investment Thesis

Strength in demand for ResMed’s (NYSE:RMD) product suite has delivered strong operating outcomes in its ventilators and respirator segment this year. We had expected this, as there has been a corresponding demand for this category of devices amidst the pandemic this year. The expansion in the ventilator segment has offset weakness in their sleep segment, however, at home testing has seen better than expected recovery in this area of the business. Furthermore, strong mask sales over this year have added weight to the strength in operating leverage for RMD over the recent periods.

Data Source: Author’s Bloomberg Terminal

Thus, we see moderate probability of future earnings growth, even though ventilator demand will likely diminish once the pandemic settles. Although, there is high uncertainty around this at present, considering volatility in global cases, especially in Europe. Additionally, the pricing environment is likely to benefit from the cancellation of the latest competitive bidding round, which will see lower pressure on pricing stability for ventilators in our view. From the above points, exposure to the downside seems to have been dampened in the near-term, therefore earnings growth, plus future catalysts surrounding ventilator and mask supply are likely already baked into the valuation. The company has also held the $1.56 annual dividend, which is a plus in our view. Therefore, we see slow earnings growth over the coming periods, and we remain neutral for the moment.

Performance and Outlook

Earnings this quarter were also underscored by strong mask sales and high operating margins that were well above management guidance. The company saw leverage from the SG&A line, which was certainly bolstered by the fact the company has booked ~$200 million in ventilator sales since the pandemic began. Considering the costs of air freighting and manufacturing, SG&A costs of 21% of revenues was impressive over Q12021, and had come down 7% over the period, and therefore drove higher operating leverage. The question remains on the sustainability of this, as operating margins will likely see a decrease as travel reopens, and with the re-integration of distribution networks. Management have guided operating margins to remain flat over the coming quarter. R&D margins for this quarter were at 7.3% on revenues of $725 million, which beat the consensus by almost 3%. Management have remained consistent in their prioritization of R&D reinvestment, which has grown by 9% quarter/quarter. Covid related sales in the ventilator segment added around 6%-7% of total revenue growth, which was expected in light of the current environment.

Impressively, the sleep segment was able to beat demand estimates, by RMD offering home testing, which has allowed a rapid recovery in this segment. This is in spite of social distancing and the deferral effects on traditional sleep testing laboratories. Management have hinted that patient testing is almost at pre-pandemic utilization, which has been supported by device upgrades as well. We believe that this segment will see headwinds into 2021, as new patient testing/diagnosis numbers are estimated to decline during this period. On analysis, new patient volumes in the US are around 70% utilization pre-pandemic, whilst China levels are around the same. This is in contrast to Germany, where new patient volumes were recorded at ~90% of full utilization relative to pre-Covid times. Management remain cautious on guidance in this area, which may already be back at ~100% of pre-pandemic utilization in new patient testing/diagnosis. The company also recorded double-digit mask sales growth, which saw benefit from integration into supply for the US, therefore capturing additional market share in this segment. These trends will likely continue, as further doubts around the coronavirus continue, and general policy indicates masks to remain in situ for the reopening of society.

Our modeling is largely in line with consensus, as we see headwinds in the sleep segment and diminishing ventilator sales, offset by strength in respirator volumes and mask sales into 2021. We see top-line growth at CAGR 6.7% over the coming 5-year period, with slight alleviation of gross margin pressure, from reduction in manufacturing and production of ventilator costs. Further, we see FCF expansion of ~7.5% over this period, which is positive as management have committed to their priority in R&D reinvestment over this time. We believe that the company can adhere to this growth, which forms our base case, and we see EPS of ~$5.40 by 2022, ~24% upgrade from the 2020 actuals. Should the pandemic continue to play havoc on hospital resource and bed utilization, then ventilator sales may see accelerated growth above our estimates, which may impact gross leverage, but see top-line growth closer to 10% in the upside case. As free cash has grown over the years, FCF margins have remained healthy, and we see the company using this as leverage to its R&D priorities.

Data Source: RMD SEC Filings; Author’s Calculations

Data Source: RMD SEC Filings; Author’s Calculations

Valuation

The company trades at 44x FCF, on a FCF yield of 2.55%, and has $4.82 in free cash per share. RMD trades at a premium to the peer median in most multiples categories, currently at 11.6x book value, and EV/EBITDA of 29x. Thus, the company trades at an average of ~60% premium to peers at this point in time. ROIC of ~19% and ROA of 14% far exceeds the weighted cost of capital of 7.9%, which helps to justify the valuation. Although, we see other high multiples as RMD is currently trading at 10x total revenues, and ~40x cash flow. Therefore, as mentioned, the valuation on a multiples front is steep, and shares currently trade at a premium to peers.

Data Source: Author’s Bloomberg Terminal; Author’s Calculations

Using our probability based DCF model, we see a fair value of ~$186, which represents around 13% downside on today’s trading. Here, we have assigned a hurdle rate of the company’s WACC of 7.9%, but also completed scenarios reflecting the opportunity cost of holding lower-risk instruments, at 11.55% for the discount rate. We have assigned a terminal growth rate of 3%, which is reflective of the company’s growth prospects in our view. Therefore, the value gap is skewed to the downside in terms of intrinsic value, in our view. Investors can see the full outcomes of inputs on our modelling in the sensitivity matrix that is shown below, paying particular attention to the highlighted box within the matrix, which represents the upper and outer limits of our DCF input implicit assumptions.

Base Case DCF Modeling:

Data Source: Author’s Calculations

RDM Sensitivity Matrix

Data Source: Author’s Calculations

In terms of a price target from multiples, we have justified the forward P/E using the dividend estimates and history of the company, arriving at a forward P/E estimate of 7.3x. Applying a 5.9x premium to the justified forward P/E, and tying this to our 2021 EPS estimates, we see a price trajectory of $220.2 for December 2021. We obtain the 5.9x premium from the average P/E scores of the previous 4 years for RMD, divided by the justified FWD P/E in our estimates. Therefore, we see a small amount of upside over the coming 12 months, as we believe a lot of the current story is currently baked into the valuation. In the grey-sky case , we assign a 3x multiple to the justified FWD P/E, and apply this to our 2021 EPS estimates, which yields a price target of around $113 dollars. Therefore, there is significant variance in the range of valuation for the company, from a DCF perspective, and when assigning our price targets on price direction. This must be factored in by investors into their expected return analysis, alongside the additional market risks for the company if being held in portfolios.

Data Source: Author

Therefore, there is significant range in the valuation, and the correlation in DCF and multiples to price outcomes, has not been high across the previous years for RMD, which makes the above valuation less accurate and the forecasts on valuation a little more murky. Hence why such a range of valuation methods have been performed in the first place. Therefore, investors must take this into consideration, as mentioned.

Further Considerations

On the charts, shares have trended in a wide ascending channel since the selloff in March. There has been a wide dispersal in price outcomes over this period, however shares haven’t broken either the upper resistance bar of lower support line of the channel to date. There was a retracement in July from quarterly results at that period, however, shares have made a recovery from September after a slow run down to the longer-term support level. Shares have since broke away from this point, having been tested again at support around 2 times since the gradual run down. Now, shares have surpassed the July highs, and look set on a nice trajectory following a strong quarter. Investors can see this activity in price direction on the chart below.

Data Source: Author’s Bloomberg Terminal

Both momentum and RSI ranges have shown considerable correlation to price direction, and shares have recently breached the RSI 70 line, into overbought territory, as seen on the chart below. This may result in a pullback towards support, however, the recent uptick has maintained direction in spite of the RSI ranges. Momentum has been strong YTD also, and has been largely absent from volatility. Momentum seem to outweigh the RSI ranges at the present point in time, showing strength and resilience in spite of the RSI figures. We therefore firmly believe that the current investor sentiment is bullish, therefore longer-term investors will benefit from this information. Those with a longer-term horizon, or holding RMD in portfolios, should keep a close eye on the RSI and momentum levels, in order to make decisions on entry, exit and reallocation/rebalancing over the coming periods. We can see this correlation in RSI and momentum activity to price direction, on the chart below.

Data Source: Author’s Bloomberg Terminal

Risks

The main risks to the company involve lower volumes than expected as a result from pandemic market influences, alongside a reduction in operating leverage that has been obtained over the last quarter. The company was able to leverage the SG&A line from the income statement to gross and EBITDA level earnings, however, higher than expected operating costs will impact operating margins, and therefore R&D expenditure. There are also sales risks that may arise from a reduction in guided product volumes, such as a sharp pullback in ventilator, respirator and mask volumes. Further, greater headwinds from a reduction in new patient diagnoses in the sleep segment is a risk to top-line earnings also. Pricing pressure in these segments is also a risk to the top, as competition from substitutes and the industry itself, may result in pricing outcomes becoming affected by a high strain on healthcare and medical resources.

On the charts, the risks pertain to shares making a sharp pullback, below support, in response to the current RSI ranges, alongside a significant reduction in momentum. Offsetting this is the current direction and strength of the longer-term trend. Furthermore, those holding RMD in portfolios should check their own portfolios’ and RMD’s correlation to the market over time, as market turbulence in the upcoming periods must be factored into investment reasoning.

In Short

RMD has had a better than expected run over the previous 2 periods, which has been on the back of strong ventilator, respirator and mask sales, from the pandemic. Although sales volume was expected, strength here has offset weaknesses in the sleep segment. However, the sleep segment has also made a nice run to recovery, as the company has offered at-home testing. We see headwinds coming into the future from diminishing COVID-19 requirements for ventilators, and although the company was able to leverage operating margins most recently, the sustainability of this must be put to the test. There is significant uncertainty around COVID-19 outcomes, although it would be argued that RMD benefits with this uncertainty, and any increase in Covid-related resource demand. There are also questions on the valuation, as a significant range in valuation outcomes is obtained with various inputs, and the correlation to multiples and DCF-type valuation to price outcomes has been low over the recent periods. This must be factored in by investors, and we also firmly believe that the future expectations on RMD’s Covid sales and other segments has already been baked into the valuation. Therefore, we see the company trading at a premium to peers, at around a 60% premium at that. Management have provided solid guidance for the upcoming periods, although headwinds do exist in the sleep segment based on lower new patient diagnoses, that have already been affected by the pandemic, but made an almost 100% utilization recovery to date. Therefore, we are neutral on the company, as there are valuation risks at hand, and a lack of drivers to add additional steam to our analysis on valuation. Further, with the uncertainty with Covid, this balances our neutral outlook also. We look forward to providing additional coverage.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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