Description

RMD is a secular decliner with 50%+ downside.  It has been an industry leader with abnormally high margins, but it is now facing significant reimbursement and competitive pressure.  Operating margins should compress from 27% to a more peer-like 16%, causing EPS to drop from ~$2.50 to ~$1.50.  The P/E should compress from 20x, resulting in a 50%+ price decline.

Overview

RMD manufactures products for the treatment of obstructive sleep apnea (OSA) including airflow generators (“blowers”), mask systems, headgear, and other accessories.  Approximately 1/5 adults in the US have some form of OSA, representing 40mm people, and roughly 8 million have been diagnosed.  35% of cases are moderate-to-severe, and 65% of cases are mild-to-moderate.

Products:

Flow generators: 57% of sales. This is the “razor.”  Flow generators last for 5 years.  There are three categories of flow generators with varying levels of air flow control depending on the severity of the diagnosis.  RMD has ceded the low level/price-competitive generators to Philips Respironics.

Masks: 43% of sales.  This is the “razorblade.”  Masks are replenished as they wear out, typically after 3 mos to 1 year, or more.  The average re-supply rate is 1.3x per year.  Masks and flow generators from different manufacturers are interchange-able. 

Geography: 52% Americas; 36% Europe; 12% Asia.

Market share:   RMD (~45%), Respironics (acquired by Philips in 2007; ~35%), Fisher Paykal (~8%), and several smaller players.  RMD has 50% share of the market for masks and 40% share for flow generators.

Customers:  Durable (Home) Medical Equipment providers (DMEs/HMEs). The market is fragmented with 3,000 mom and pops and 3 larger players: Apria, Lincare, and Rotech which have ~40% share.

Payors:  In the US, 20-25% of end users are reimbursed by Medicare, and 70-75% is reimbursed by commercial payors.  Outside the US, payors are generally the government health plans.

Short Thesis

Margins are unsustainably high

RMD’s extremely high margins make it an outlier among medical equipment companies despite the fact that it sells unsophisticated/low-tech plastic blowers, tubes and masks.  This is the result of RMD’s early leadership and strong brand in a new and growing market, and the fact that reimbursement levels previously did not get a lot of scrutiny because it was a small category.  RMD’s margins are unsustainable now that the industry is more mature and facing reimbursement pressure and increased competition.

Gross margins are estimated to be ~80% for masks and tubing. G/M for flow generators is estimated at ~40%.  RMD’s consolidated G/M is 64% vs other medical equipment companies at 51%.  The EBIT margin is 26% vs comps at 16%.   RMD said it took a “step change” price cut in the March quarter and that it is willing to sacrifice gross margin to grow the top line.  Gross margin guidance for FY 2015 is 61-63% vs 63.7% in FY2014.  I believe this is the start of several years of declining margins.

Below is a table showing the margins for a broad group of medical equipment companies.  It is clear that RMD’s margins are abnormally high.

Competitive bidding:

20% of US sales (or 11% of total sales), are ultimately reimbursed by Medicare.  Medicare has been actively cutting reimbursement rates through the Competitive Bidding Program.  Medicare is also using the program to drive consolidation of the mom and pop DME industry in order to get more efficiency.

Round 1 of Competitive Bidding went into effect on January 1, 2011.  It covered 10% of the country and prices dropped ~30%.    Round 2 of Competitive Bidding went into effect in July 2013 and covered half of the nation.  Prices dropped 47%.  Round 3 of Competitive Bidding goes into effect on January 1, 2016 for the final 40% of the nation.  Price reductions are directly borne by RMD’s customers, the DMEs, but:

DMEs have been looking to RMD for price cuts.  Estimates vary, but I believe DME’s are initially getting 10-15% price cuts.  Not all DMEs are treated equally.  RMD has said it is willing to offer discounts for volume commitments.

The highly fragmented DME channel is consolidating, strengthening larger players that have more pricing power over RMD.  In other words, RMD’s lowest margin customers are growing bigger.

Philips/Respironics has been especially aggressive with price in order to gain share in the last year.  And, it came out with a low-end CPAP machine to help DME’s offset the margin hit from competitive bidding.

Bundling:

CMS is considering moving to a bundled payment scheme whereby it would pay a fixed monthly rate for all supplies.  In July, CMS announced it will trial bundling in 12 regions in 2015. It is supposed to be a 3 year trial, so a final decision won’t be made until 2018. While the details are unknown, bundling is generally viewed as a negative for the industry.   

Barron’s had a piece on RMD in June saying, “Home medical dealers say ResMed execs have confided that bundling would be the worst thing possible for CPAP makers. "Trust me," says a large dealer. "They are definitely worried."”

Pricing pressure from commercial payors:

Our checks indicate that commercial payors are starting to follow Medicare prices.  I roughly estimate that before competitive bidding private payors were paying ~33% less than Medicare.  This was unusual b/c Medicare typically gets the lowest rates, but Medicare’s reimbursement levels before competitive bidding were extremely stale.  After Round 2, commercial payors would have been paying ~26% more than Medicare.  Our checks indicate large payors think they can negotiate prices -10% lower than Round 2 prices, and that they will consolidate contracts with the largest DMEs. 

Reinvigorated Competition from Respironics.

RMD has said that one of the reasons for its success is that its largest competitor, Respironics, was poorly run in the first five years after it was acquired by Philips in 2007.             

RMD indicated for the first time this year that it lost some market share to Respironcs b/c Respironics’ new line of products was strong.  Also, we have heard that Respironics is being very aggressive on price to gain share.

A low cost Chinese player has entered the market.  They have not gotten traction, but the largest DME did experiment with them and used them for negotiating leverage.

Tighter Compliance Standards

Medicare has progressively increased its compliance standards overtime and commercial payors are starting to follow.  This standards are intended to reduce unnecessary costs, which means less revenue for RMD.

In 2009 Medicare started to require evidence that patients are using the device for four hours per night in the first 90 days.  This created an audit burden for DMEs. By one report, Medicare usage dropped -15%, although RMD IR denies this.  RMD has said that commercial payors are starting to adopt this 90 day compliance rule, but it sounds early.

There are allegations that DME’s automatically ship new masks when the patient is eligible (3x per year for Medicare; 2-3x per year for private payors) even though the patient has not requested it, so called “drop shipping.”  In June 2012 Medicare issued a new rule effective in August 2012 that DME’s can only provide a replacement when the original item is no longer functional, and the cause of the dysfunction must be documented.  Our checks showed that mask replenishment rates have dropped between 5-20% as a result of the
rule.  Private payors are expected to follow suit, but so far there is mixed evidence. 

Most recently, in May 2014 CMS issued a new proposed rule calling for pre-authorization documentation as a condition to reimbursing supplies. CMS says that 50% of reimbursements have “improper” documentation.  There are some limited reports of HMO’s starting to require pre-authorization as well.

Europe exposure:

Europe is 37% of sales and I believe margins are higher than the US as a result of more generous reimbursement schemes.  RMD has occasionally offered cautious comments about European sales because of reimbursement pressure from government healthcare schemes as a result of austerity. 

Penetration:

There is a view that the market size is best represented by the 10-12mm moderate-to-severe cases in the US, which would imply that the market is already 66-80% penetrated.  Furthermore, some would argue that there has been a trend towards over-diagnosing for the benefit of the sleep-health industry, made up of sleep doctors, sleep testing clinics, DMEs and equipment providers.  A senior exec at a large health insurer told us that OSA is a “fad diagnosis.”  Payors are starting to catch-up with tightened rules that crack down on over use.

Alternative therapies:

There are a couple of cheaper therapies, but there is no indication that they are making a dent.

Accounting red flags:

RMD lowered its warranty provision by $8mm in FY 2014 which was a 50 bps benefit to margins, and +2% benefit to EPS.

DSO’s are up to 79 days from 70 last year.  RMD said it is extending payment terms.

Valuation:

RMD’s P/E is 21x/19x 2015/2016 (FYE June) which is roughly in-line with its historical range.  This is based on consensus estimates, but I think EPS will decline 10-15% per year for several years. 

 I think RMD’s margins should compress significantly over the next few years (from 27% to a more peer like 16%).  This should result in EPS going from ~$2.50 to ~$1.50.  Meanwhile the P/E should compress to a more “average” multiple, say 15x, resulting in a price decline from $50 to $23.

RMD has $4 per share of net cash, but almost all of this cash is outside the US. 

Bull View

The secular growth story:

Secular growth tailwind from large undiagnosed population.  RMD and Respironics/Philips both believe the global market is growing 6-8% (~5% for flow generators, and ~10% for masks due to faster replenishment rates).  RMD believes it can grow faster than the market.

The sell-side believes RMD can grow the topline 8-9%.  I think RMD will grow low single digits due to price declines

Increased mask replenishment rates (i.e. sell more razorblades): 

Private payors reimburse for 2-3 masks per year and Medicare reimburses for up to 3 per year.  Currently, the replenishment rate is <2x per year.  Large DMEs have set up call centers to call patients when they are eligible for new masks, and RMD has been encouraging smaller DMEs to work with outsourced call centers in order to “push” faster replenishment rates.  Regardless, RMD says that replenishment rates have been fairly flat.

Market power and patient/doctor lock-in:

RMD has had dominant market share of masks at ~50% due to superior comfort which allows for better “compliance” (i.e. patients actually using it, so DMEs can get the recurring replenishment revenue).  But, Respironics launched a new line of masks in the last year which are now viewed as on par with RMD.  Previously, Respironics’ masks were viewed as inferior. 

Doctors prescribe by brand ~40% of the time.  I believe that DMEs are starting to pushback on prescriptions by brand because DME’s have a heightened focus on providing the lowest cost supplies.

New Products:

RMD launched 3 new masks in the last ~6 months and launched a new flow generator as part of its A10 platform which replaces its S9 platform.  The new masks are smaller and lighter.  The new flow generator is smaller and sleeker, and it includes built-in wireless capability versus the prior version has a remove-able data card and an optional wireless modem.  The wireless capability helps DMEs monitor compliance. It also has a diagnostic feature which could theoretically help the DME’s cut back on service calls. 

Pricing is comparable to the prior version and margins are initially lower, which is one of the reasons for RMD’s lower G/M guidance for FY 2015.

The perception is that historically RMD has gotten a sales boost after launching a new platform, but I think the last few product launches have contributed a negligible boost, if at all.  Logically, this is not a hot product that consumers are running out to buy like the iPhone 6.  Management has made somewhat reserved comments about any sales benefit.

Adjacent growth areas:

RMD management talks about its “Three Horizons” growth strategy including: 1) CPAP for sleep apnea, 2) CPAP for treating COPD, ventilation products and emerging markets, and 3) CPAP for treating heart failure patients.  Basically, RMD is trying to expand its market with various versions of its respiratory devices.  None of these initiatives is a needle mover.

In ventilation, RMD recently launched a product, Astral, which provides hospital-like life support ventilation for at home use.  It is a $200mm market.  If RMD gets 25% share, that’s +3% to revenue.

For heart failure, RMD is conducting a 2+ year study in Europe with 1,325 patients who have heart failure and sleep apnea in order to determine if ventilation treatment can help outcomes. The study will be completed in 2015 and results published in 2016.  RMD said this is not a game changer in terms of revenue, but it would help the company maintain a higher growth rate longer term.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

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