Description

I recommend shorting Resmed, RMD.  RMD is an overvalued supplier of sleep apnea devices, whose core business is facing slowing growth, increasing competition and regulatory headwinds.  In response to these challenges management is attempting to diversify into adjacent fields through value destructive M&A. 

Brook1001 previously wrote up RMD in October, 2014.  Please refer to that for some background.  Much of the thesis remains the same, but he was a bit early as much of the pressure on the business was offset by the launch of the Airsense 10, RMD’s new flow generation equipment.  There are also a number of new developments worth highlighting.

RMD is a developer of medical products for the diagnosis, treatment and management of respiratory disorders with a focus on sleep disordered breathing, principally obstructive sleep apnea, or OSA.   57% of sales are in the Americas and 43% is rest of world.   Likewise, 57% of sales are flow generators, while 43% are masks and accessories.   Masks are consumable, have steadier growth, and gross margins that are much higher than corporate average (possibly by 1000bps).  In the US approximately a quarter of sales are Medicare.   With regards to market share, RMD is the industry leader with approximately 45% (over 50% in masks), Philips Respironics has roughly 35%, and a number of smaller competitors make up the balance.  It sells its products through durable medical equipment (DME) distributors.

RMD trades at $59.75.  There are 144 million shares outstanding including options and RSUs, for a market cap of $8.6 billion.  Pro forma for the Brightree acquisition, there is $559 million of cash and $1.1 billion of debt, for an enterprise value of $9.1 billion.

Management points to statistics claiming that roughly a quarter of the adult population in the US has some form of OSA.  This dramatically overstates the addressable market.   There are only 10-12 million moderate to severe cases in the US and the market is close to full penetration and fairly mature.  Due to anemic growth outlook in the core business, management has been interested in expanding into other adjacent fields through what it refers to as Horizon 3, referring to three potential growth areas: heart failure, COPD and other illnesses requiring ventilation therapies, and now through M&A activity.

Sleep disorder testing and treatment is a lucrative business, while test results can be inconclusive and vague, yet still qualify patients for treatment and expensive equipment.   Patient compliance is often an issue because the discomfort can outweigh the perceived benefits.  For these reasons, Medicare and private payors are trying to reduce waste, inefficiencies, and fraud, ie they would prefer to pay less in reimbursement.   To address this, regulators are enacting competitive bidding, requiring preauthorization, and proposing bundling. 

Last month, CMS released the results of the 5^th round of competitive bidding (competitive bidding round 2 recompete), which will go into effect 7/16.  New single payment amount rates are 10-15% lower the previous competitive bidding 2 rates, which was a little worse than they were expecting.  The higher than expected cut will lead to lower DME profitability, which could also potentially lead to DMEs demanding greater price cuts from RMD and pushing lower cost products from competitors to patients.  This is also likely to reinforce the trend towards industry consolidation with national providers gaining share, which are less profitable to RMD.

At the end of 2015, CMS announced that it expects to institute preauthorization for certain items over a certain price.   This could result in less incentive to over diagnose sleep apnea and lead to less unnecessary shipments of equipment and accessories.

CMS has also announced a pilot for bundling that would simplify competitive bidding by setting bid limits for monthly expenditures.   This could lead to a dramatic reduction of higher margin mask and accessories sales.

RMD launched a new flow generation line, the Airsense 10, in the fall of 2014, which was the first refresh since 2010 and which jump started sales.  The introduction was very successful, with flow generators growing 53% 6/15, 39% 9/15, and 23% 12/15.  However, RMD is now facing some very tough comps and historical perspective indicates that the growth rate will continue to drop precipitously from here after the rapid uptake from the introduction.  So despite the pricing pressure hitting gross margins, RMD has increased gross profit dollars due to top line strength over the past year, but now that revenue growth is moderating it will begin to feel the impact of lower margins.

To compound the decelerating growth rate and regulatory pressure, Philips Respironics launched its Dream Family platform in October, 2015, with new CPAP machines and masks.   There have been no major competitive introductions over the past few years, so this one could have an impact.  There is little differentiation in terms of functionality of these products, but RMD is generally enjoys better brand awareness and has led the industry in integrating data, so its competitive position appears to be slightly better than Respironics.   Respironics is pricing aggressively, however, to gain market share.   Discounts of 20% are common on comparable devices, so I expect that this product launch will have an impact on RMD by further pressuring margins and further decelerating the growth of the Airsense 10 line.

One of the more promising future growth areas for RMD was ventilation therapy to treat chronic heart failure patients with sleep apnea (part of the Horizon 3).  However, in 5/15 the results from its SERVE HF trial were released.  Not only did it fail to meet its primary end point, but it was actually revealed to be life threatening as it increased the risk of mortality in a specific group of patients.   This was a hit in the high single digit range to out year earnings estimates, further reducing internal longer term growth prospects.

Management teams are often eager to point out and quantify FX headwinds when the wind is going against them, but seldom highlight the tailwinds they receive.  Many US based multinationals have been feeling the pain of the strengthening USD and RMD has felt an impact on its top line given about half of its sales are international, with much of that coming from Europe.   In the most recent quarter, rest of the world sales were -4%, but in constant currency they were up 7%.   What is not prominently displayed is the FX tailwind that RMD benefits from because a significant portion of COGS and R&D are denominated in AUD, which has generally been declining against the USD the past few years.   On the most recent earnings call during the Q&A management stated that gross margins got about a 40bps boost due to the weaker AUD in the quarter, so this currency movement has been providing a temporary and unsustainable boost to margins that has partially offset the prevalent pricing pressure.

What is one to do when one’s core medical device business faces intractable challenges?  If you said become a “cloud based SaaS provider” and compete with your customers via a misguided M&A strategy, then you might need to check your premises, but you would have correctly guessed the strategic direction RMD has taken.   RMD historically has not been that acquisitive, averaging about $30 million per year in tuck in acquisitions, but in F2Q16 (12/15) it spent $155 million on three acquisitions.  Then in F3Q16, it announced two more acquisitions, one with no terms disclosed and the other for $800 million.  Management appears to be taking a shotgun approach to acquisitions in order to bolster the top line without any clear strategy and destroying value in the process.

There were no terms disclosed for the F2Q acquisitions because they were not deemed material.  Shareholders might hope that for $155 million that something material was acquired, but alas no such luck.  It appears that these acquisitions are either horrible capital allocation or will result in quite the spring loaded cookie jar for management to hide deterioration in the core OSA business.  In addition to the immaterial revenue, of the $169 million of net assets acquired there was $23 million of current assets and PP&E.  The rest were soft assets with $115 million of goodwill and $26 million of customer relationships.

The acquisition of Brightree is the largest to date at $800 million.  Brightree did $113 million of sales in 2015 and $43 million of EBITDA, so RMD paid 7x sales and 19x LTM EBITDA.  Management points out that Brightree is growing revenue at a double digit rate.  DB suggests that it grew 17% in 2015, which was a deceleration from ~30% the past few years before that.   Brightree was also a bit of a roll up, itself, having done six acquisitions since 2008, so its organic growth could be lower.  Brightree provides cloud based HME billing, inventory management and accounts receivable software, so it allows RMD to provide new solutions to customers that will allow them to automate a number of labor intensive aspects of their business.  This is quite a leap into a new business, but management is hopeful this will help them to drive more replacement orders.  Management is also cognizant that it has to reduce costs dramatically throughout the supply chain to keep its customers healthy, since reimbursement rates have been declining in the US and Europe.

Working capital management has become an issue worth paying attention to.  Inventory days increased from 101 F14 (6/14) to 133 F1Q16 (9/15), before falling to 120 in F2Q16 (12/15).   Five years ago RMD used to run with much higher inventory levels, so 120 is not all that high historically, but is still elevated and has been heading the wrong direction.  Given the aforementioned issues, it is worth watching as a precursor to potentially stagnating growth. 

Over the past few years, RMD has also begun using independent leasing companies to provide financing to customers for the purchase of RMD products.   In some cases RMD is liable in the event of a customer default for unpaid installment receivables transferred to the leasing companies.   For the six months ended 12/31/15 RMD sold $31.5 million of gross receivables, up from $12.8 million for the same period the prior year.  RMD sold a total of $31.5 million for all of F2015 and $6.6 million in F2014.  The maximum potential contingent liability is $10.3 million.  This calls into question the quality of revenues and the health of the DME channel.  

Management has also been drawing down its product warranty liability to the point where it cannot reasonably be reduced further.   In F2013 warranty liability was $16 million or 1.1% of total sales.  By 12/15 it had fallen to $10 million or .6% of sales.  This has boosted margins offsetting pricing pressure, but will no longer be a tailwind as this cookie jar is now empty.

RMD will generate about $1.8 billion in revenue in F2016 (6/16), $525 million of EBITDA, and $2.57/share.   Therefore, RMD is trading at 5x, 17x, and 23x, respectively.  RMD’s 10 year average EV/EBITDA is 11-12x and its 10 year average P/E is 19x.   F2017 organic revenue growth will be flattish and there will be continued margin pressure.  Given the challenges and declining margins, RMD should face significant multiple compression.

Insiders have been constant large seller of stock, tens of millions in the past year.

In summary, shorting RMD is compelling now due to the acquisition binge, tough comps, increasing competition, pricing pressure/margin compression, regulatory pressure, and stretched valuation with the prospect of downward earnings guidance.

Catalyst

Slowing growth

Price pressure

Regulatory action

Margin compression