Has Team Finance Given You A Golden Opportunity?
What would you say if I told you there was an Australian industry that can do something slightly more impressive than dig giant holes in the ground and build more houses so we can trade them amongst ourselves? Crazy, right?! Well, I'm about to walk you through an interesting, profitable, and world leading healthcare technology business and it isn't even CSL. Welcome to the world of disordered breathing, snoring while you sleep, and gradually dying by lack of oxygen, or not, for those fortunate enough to be diagnosed by their doctor and treated by ResMed.
A short primer on ResMed and OSA
ResMed began its life as an experiment at the University of Sydney in 1986. The founder of ResMed, Peter Farrell, then working for Baxter, discovered the opportunity and convinced Baxter to fund the research towards commercialisation for three years. After that time Baxter let the project go and Peter grouped together $1.25m and bought the rights to the project for himself.
ResMed runs on the business model made famous by the PC printer companies. They sell the units to customers (the current AirSense 11 unit costs $990) and then sell highly marked up breathing tubes and masks for the life of the unit. In addition to this, the Research & Development team are constantly creating new units with greater features than run quieter in order to entice patients to trade up to the new unit and associated masks. The best part about this business however is that the patient is rarely directly paying. With ResMed operating in rich countries with high levels of private health insurance penetration it is often the insurers footing the bill for the units and replacement parts. This makes the patients largely price insensitive. The cream on the cake is this; so are the insurers. It is after all cheaper to pay for a high quality CPAP (Continuous Positive Airway Pressure) unit and accessories than it is to pay for the long term impacts of untreated obstructive sleep apnea.
Obstructive sleep apnea (OSA) is where someone stops breathing for short periods during their sleep. The worse the OSA, the longer and more frequent these pauses can be. The 'obstructive' part of OSA refers to the obstruction of the upper airway as it narrows due to relaxation. CPAP machines keep the upper airway open by applying constant pressure which gently forces the airway open. Patients invariably feel so refreshed and recharged by having a full night of uninterrupted sleep once they begin using their CPAP machines that they are hooked for life. In fact, they are hooked for a longer life as they also extend their life expectancy as well as the quality. It is currently estimated by the University of Minnesota that 30 million Americans have sleep apnea while only 6 million have been diagnosed. ResMed has made its living helping that first 6 million and will make its next fortunes helping the other 24.
Why would ResMed list on the NYSE and what is a CDI?
ResMed has a dual listing. One set of shares are listed on the ASX and another are listed on the NYSE (New York Stock Exchange). Although this is common enough you are probably wondering why a company might do that and, once deciding to do so, why they might list a CDI on the ASX. In fact, you might be smart in asking exactly what the hell a CDI is. Let's dive into it together.
Let's start at the end and work backwards. A CDI stands for CHESS Depository Interest. This is a structure that allows ASX investors to gain an interest (buy a share) in an overseas listed company. In this case it is done so Australian investors and ResMed holders can deal directly with the ASX and save the hassle of overseas markets. In the circumstance of ResMed it is a 10:1 CDI, which means that each NYSE stock has the value of 10 ASX CDIs. In other words, if you purchase the CDI, you will get paid 1/10th of the dividend but you'll also pay 1/10th of the price.
Briefly we can touch on the arbitrage traders of the market. You see, at all times other than when a dividend has been announced ResMed shares on the NYSE can be exchanged for ten times as many CDIs. This helps ensure that the price in AUD is always the same as the USD value on the NYSE. If the price ever drifts then arbitrage traders will request a conversion of shares and make immediate and risk free returns equal to the difference. That's a geeky way of saying that the price in both markets will always track the same and this should keep you at ease no matter which market you choose to invest in.
The next question that needs answering is why list in America at all? The simple truth is probably that the US has a deeper capital market willing to pay a higher price at a lower cost. When it comes to funding a company this is exactly the kind of thinking you want a management team to be making.
Fun fact about picking where to list your shares. When the buy now, pay later (BNPL) boom was going off, even US based companies were choosing to list in Australia. Why you might ask? Simply put, Australian investors have proven to be the biggest set of degenerate gamblers willing to pay obscene sums for the promise of a BNPL share market lotto ticket in the world. In all fairness, well done to those same 'investors' (I'm suggesting, disparagingly, that they were in fact speculators) who rode the Afterpay rocket and cashed out before Block took them over. Given Block has lost tonnes of money on that deal ever since I might think they've got some buyers remorse. Obviously, that's a fairly large tangent just to say that companies try and pick the best markets they can in which to raise the most amount of money at the lowest cost. For this reason, ResMed primarily chose the NYSE with a secondary listing on the ASX.
How has the company performed?
In 1995 ResMed listed on disallowed at a price of 67 cents. There was a market need identified and the company went about fulfilling it. Fast forward 28 years and the share price has increased roughly 220 times. For reference, this would have turned a $5k investment into $1.1m. In the last 11 years alone the company has grown revenue by 11% a year, profit by 12%, and the dividend by 9%. Even at this year's record cash payout to shareholders the dividend only consumes 37% of the net operating cash flow, or 28% of profits. Of the $2.6b of capital deployed over the last 3 years, 30% has gone to the R&D (Research & Development) team, 42% has been spent on acquisitions, and 28% spent on shareholder dividends. Although dividends are nice, and growing at a healthy rate, it is highly encouraging that a growth company is ploughing 72% of its capital into developments that grow the size, strength, and profitability of the business.
When looking at companies that are still growing, they will, by their nature, be heavily reinvesting in themselves. As pointed out earlier, the last three years have seen a huge amount of R&D spend which goes hand in glove with their new acquisitions. The company has decades of data on their patients and how they utilise their products. The average user replaces their entire breathing unit every 3 to 5 years. The 7% of revenue per year, currently $294 million, helps ResMed create better, quieter, cloud uploading, doctor and patient friendly interfaces that drive customers toward the updated and upgraded models. With the strive for perfection driven from the top of the company it is easy to imagine them as the Apple of airway machines. Which brings us to a perfect segway to look at ResMeds second rate competitors, much like Apples.
In 2022, Phillips, a major competitor, had to come out and issue a large-scale recall due to patient safety concerns. What is the upshot of that? Well, suddenly Phillips patients were asking themselves how safe it was to use the Phillips device and many of them switched to ResMed. The company extended its lead and gained $250m in sales. With Phillips out of the market for at least 12 months it is expected that ResMed will keep the majority of customers they win over that time. The market predicted an additional $600m in sales opportunity was now up for grabs. Over the next 12 months to June 2023, how much of that $600m market did ResMed capture? $547m in additional sales, or 91%, of what was expected to be available.
A new string to the ResMed bow has been the SaaS (Software as a Service) offering. This is the data upload, interface and interaction which allows patients to send sleep data to physicians online and have interactions with their medical specialists in their own home. In 2022 this business accounted for $400m in sales, increasing to $498m in 2023 (25% growth). It is also helpful to the profit line that the SaaS portion of the company operates on a 65% profit margin which is higher than the 55% gross margin the sleep and respiratory care products division earns. To put this in perspective, Apple operates on a gross margin of 44%.
Now this will be a small detour but I want to walk you through a small amount of ResMed share price history. You see the thing is, everything you are going to read in this document is common knowledge and the market has known it for ages. The potential addressable market for ResMed has always been huge and because it has always grown into the market things have pretty well always looked bright. It is hard to multiply your company value 200 plus times otherwise. But the market can, and does, get carried away. For example in September 2021, almost exactly a month after releasing their 2021 annual report ResMed shares hit $295. The earnings to justify this value came to $3.24 a share. That’s a P/E (price to equity) of 91. Now a lot of things have to go right for a company in order that paying this much for it is a good idea. To be fair to the legion of people who paid up for ResMed shares it was, and still is, a growth company. The bulk of the money left after the cost of production goes into R&D and acquisitions to grow the company and serve the huge market. For now, I just want you to remember that PE of 91 because it will be important later.
Be honest though, what are the risks?
There are four key risks to the future success of ResMed. Competitors taking their market share or destroying their market, the drying up of the market for readily accessible patients, a general market downturn or recession, and the recent emergence of GLP-1 receptor agonists.
Although it is always possible that an alternative to the CPAP is found to treat OSA, to date ResMed has seen off all contenders from nasal prongs to healing balms. This is mostly because the positive airway pressure is such an effective way of maintaining the airway during sleep. The more realistic threat of competition comes from a direct competitor. However, given we discussed Phillips (#2 in the market) earlier it is fair to say, as of today, that this threat is unlikely to usurp ResMed. As a partial mitigating factor to this however the R&D team at ResMed are now the owners of over 9,000 patents which limits competitors' access to their advanced designs.
It is also possible that ResMed has already found all of the low hanging fruit and the market is saturated. If we go back to the point we raised earlier it is hard to believe that ResMed won't have at least a few more years of growth if roughly 24 million people in the US alone have OSA but are currently undiagnosed. Of course, if this is true then now may be the time that ResMed switches from full on R&D and acquisition spending to cash flow generation and maximising shareholder returns via dividends and share buybacks. After all, in a world where they are no longer treating new cases of OSA, what else is there to do with all of that cash?
Probably the second largest risk to the share price is a downturn in the economy. This may hit ResMed in two ways. The first will be to 're-rate' the equity risk premium paid for their shares and the second will come from reduced customer demand as people lose jobs and drop their private health insurance. As with all companies working in the health space there is little ResMed can do to avoid customers dropping out of the health system other than to provide them with a product so good that, at worst, they would be willing to pay for it themselves out of pocket should that occasion arise. We will see how this plays out but a brief look at the share price over the GFC and tech bust suggests that there is hope for the company yet, even in a heavy recession.
The big gorilla risk however is the appearance of slow thinking (finance people aren't that bright after all) hedge funds who, after GLP-1 receptor agonists have been on the market for years, have just realised they might eat into profits. When Novo Nordisk released their results stating that cardiovascular events are reduced with patients using their drug, ResMed shares dropped 20%. To this point, the short sellers are having a field day.
A lot has been made recently of the UBS report stating that as much as 18% of ResMed's revenue could be at risk should the GLP-1 market grow to 35 million people. How so you might ask? Well, one of the major causes of OSA is when patients carry extra weight and that impacts their breathing during the night. Just imagine putting a few (or a lot of) extra kilos on your chest and neck and trying to get a comfortable sleep.
The theory here is actually quite sound but, as usual, the finance guys have tried to make themselves sound smart. They will say that reduced OSA is a 'second order' effect of this new and highly effective weight loss drug. The 'first order' effect of GLP-1 is the loss of weight itself and anything that occurs as a result of this is a second order impact. In the US, Novo Nordisk only claims to be treating 'hundreds of thousands' of patients with Wegovy (Ozempic, Semaglutide - it's all the same). Even the AMA (American Medical Association) estimates there are 30 million people in the US with obstructive sleep apnea. If the venn diagram of these two groups were perfectly overlapped, Novo Nordisk and their competitors would have years of double digit growth before putting a serious dent in the number of OSA patients. Furthermore there are other problems with the comparison. Namely, not everyone with excess weight is willing to use Ozempic. They either don't want to 'cheat' using a drug to lose weight, don't want to use subcutaneous injections, or don't want to suffer any side effects. And with the side effects it should be noted that the nausea and vomiting were bad enough, even in the trials, that 17% of participants exited the program. And a recent study has found that, in the US, only 32% of patients prescribed Wegovy/Ozempic were still using it a year later. To summarise, I think the finance guys (and they are predominantly guys) are trying to be too clever by half here. They likely missed the Novo Nordisk share price spike and are now trying to piggyback on the trade with second rate solutions while posturing that they are unique snowflakes. Don't believe them.
In saying that, we should make no bones about it, excess weight is the strongest risk factor for developing OSA. This finding is from the Royal Australian College of General Practitioners (an excellent reference resource if you happen to study medicine by the way). They estimate that 58% of moderate to severe OSA is caused by obesity. Hence, we must realise that GLP1 drugs, which are highly effective, will reduce patient weight and could lead to those same patients no longer needing to use ResMed products. More insidiously, they may limit the flow of future patients. But just as I asked you to remember the number 91, I ask you to remember this entire section of risks.
Have business scares like this happened before?
There is every possibility however that this is ResMeds 'Kodak' moment. The point where the balance tips and the once all conquering company is brought undone by an upstart technology. The stupidity that Kodak discovered digital photography but never commercialised it for fear of undercutting their every so profitable films business is the stuff of MBA case studies. A similar thing happened at Xerox-PARC when the Xerox corporation took over the Palo Alto Research Company. The team at PARC were so far ahead of their time in the discoveries they were making that it is a travesty they went to waste in the all consuming corporate structure of Xerox. For a simply fabulous book on that period at Xerox-PARC you simply must read Dealers of Lightning by Michael Hitzik.
All of this is to say that a special mention must be made of the recent GLP-1 developments. It is of course possible that our society has discovered a drug that can reduce and potentially eliminate obesity in our lifetimes. If this comes to pass it will also remove patients that would otherwise treat their OSA with ResMed. The share price of ResMed has been beaten around on that premise but brave investors who can either see the future (they can't) or are willing to accept the risk of being wrong have what could be a golden opportunity. And, for what it's worth, the author of the UBS report stating 18% of revenues at ResMed could be impacted has come out and stated she thinks the market reaction has been overblown.
Conclusion
ResMed is still a growth company. This goes most of the way to explaining the circa 1.5% dividend. Hard to believe after growing their share value 220 times but there it is. With so many people in wealthy countries still suffering undiagnosed OSA or having under treated COPD and asthma the potential untapped market is enormous. Should the day come that the largest amount of cheap to obtain patients is reached, be assured ResMed will become a cash cow dispensing dividends and share buybacks in bulk.
But all of this must be put up against the 800 pound gorilla in the room and here is where I’ll ask you to remember the PE of 91 and the entire section on risks. It is not just possible, but likely, that the new era of GLP-1 receptor agonists will reduce patients' weight to the point they no longer have OSA or never develop it. It is this risk that the market has been laser focused on for 2 years. In that time ResMed has simply soldiered on releasing new breathing units, better and brighter than the last, and earning more money. How much more? They took profits from $3.24 a share to $6.09 a share. The market has also done its part and taken the share price from $300 to a shade under $150 today. So now this growth company, still expanding revenues, profits, and importantly the dividend at or near 10% a year is trading at a PE of 24.
It is possible GLP1 drugs will blow up the ResMed business model. But it is also possible the two products exist side by side. It is very likely that as good news for GLP1 comes out it will negatively impact the ResMed share price. ResMed will have to win this with the sheer power of compounding growth. If this all feels a little too stressful please purchase the excellent S&P 500 index fund. Let me take this last chance to make sure you truly understand the trade off being made. You are getting a fast growing, extremely high quality company at a very fair price but to do so you also have to suggest the market has the story wrong. Many people have lost a lot of money this way but Warren Buffett probably explained situations like this better than I ever could; “You pay a very high price in the stock market for a cheery consensus.”
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