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ResMed: Are obesity drugs making the future bleak?

Opdateret: 25. apr.

ResMed is a reputable company that has consistently delivered strong performance. If you had invested in the company when they went public, your shares would have appreciated by over 20.000%. However, the introduction of obesity drugs from Novo Nordisk and Eli Lilly has made the market apprehensive about the future of ResMed. Should you avoid the stock or does it present an investment opportunity? This is what I will investigate in this analysis.

This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.

For full disclosure, I should mention that at the time of writing this analysis, I do not own any shares in ResMed. If you would like to copy my portfolio or view the stocks in my portfolio, you can find instructions on how to do so here. I don't own shares in any of their direct competitors either. You can purchase ResMed's shares or fractional shares on eToro. eToro is a highly user-friendly platform. The minimum deposit starts from $50 USD.

ResMed was founded in 1989 in Australia but relocated to California, United States in 1990. ResMed is a medical equipment company. It primarily offers cloud-connectable medical devices for the treatment of sleep apnea, such as CPAP devices and masks, as well as chronic obstructive pulmonary disease (COPD) and other respiratory conditions. Their product line includes devices, diagnostic products, mask systems, headgear, and cloud-based software. These products are primarily used in home settings and are all connected to ResMed's out-of-hospital platform. This platform supports professionals and caregivers in monitoring the user of these devices. ResMed employs more than 10.000 people and sells its products in over 140 countries through a combination of wholly owned subsidiaries and independent distributors. However, they only sell their software as a service (SaaS) products in the United States and Germany. ResMed generates 53% of its revenue from devices, 35% from masks and others, and 12% from software as a service. Their largest market is the United States, Canada, and Latin America, which contributes 58% of the revenue. Europe, Asia, and other regions contribute 30% of the revenue, while the remaining 12% comes from software as a service. ResMed has established a strong brand reputation for quality and reliability, which is crucial in the healthcare sector. This strong brand reputation is what gives ResMed a brand moat.

Their CEO is Michael Farrell. He joined ResMed in 2000 and held various leadership positions until he became CEO in 2013. Before joining ResMed, Michael Farrell worked in management consulting, biotechnology, chemicals, and metals manufacturing at companies such as Arthur D. Little, Sanofi Genzyme, Dow Chemical, and BHP. He holds a Bachelor of Engineering with first-class honors from the University of New South Wales, a Master of Science in Chemical Engineering from the Massachusetts Institute of Technology, and a Master of Business Administration from the MIT Sloan School of Management. He serves on the Board of Directors at ResMed, the Advanced Medical Technology Association, and Zimmer Biomet. He is also the son of Peter Farrell, the founder of ResMed. Michael Farrell has done a great job as CEO. Under his ten-year tenure, the market cap of ResMed has grown from $6 billion to over $20 billion, while also delivering a shareholder return of more than 200%. According to Comparably, Michael Farrell has an employee rating of 85/100, which puts him in the top 5% of similar-sized companies. This indicates that he is well-liked by employees, which is often a positive sign. However, he can also make tough decisions for the benefit of the company, as exemplified by the latest cost-cutting plan. This plan entails ResMed cutting 5% of its positions. These decisions are never easy but have to be made sometimes. I appreciate Michael Farrell's extensive industry experience, his track record of delivering positive outcomes, his ability to make difficult decisions, and his personal connection to the company as the founder's son. Thus, I feel comfortable with Michael Farrell leading ResMed in the future.

I believe that ResMed has a strong moat. I also have great confidence in the management. Now, let us investigate the numbers to determine if ResMed meets our criteria for having a strong moat. In case you want an explanation of what the numbers represent, you can refer to "MY STRATEGY" on the website.

The first number I will investigate is the return on invested capital, also known as ROIC. Ideally, you would like to see a return on invested capital (ROIC) above 10% in all years. ResMed has consistently delivered a high return on invested capital (ROIC). They have achieved a ROIC above 10% for the past ten years, which is impressive. ROIC reached a record high in 2022 but dropped in 2023. However, I still think it is impressive that ResMed managed to deliver a return on invested capital (ROIC) above 15% in a very challenging fiscal year 2023. Overall, I am really impressed by ResMed's ability to maintain a ROIC above 10% over the past ten years, which makes it an intriguing investment opportunity.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. The numbers look good for ResMed, as they have only experienced negative growth in one year, which was back in 2015. One year of negative growth is not a concern, especially when it occurred so long ago. ResMed is a prime example of how you would like to see equity growth over a ten-year period.

Finally, we will investigate the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. Levered free cash flow margin is used because I believe that margins give a better understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. It is not surprising to see that ResMed has had positive free cash flow in all years. Free cash flow has been growing and has reached a new since 2020. It continued to grow every year until a challenging fiscal year 2023. A slight decrease in 2023 does not concern me, and ResMed still managed to deliver their second-highest free cash flow in 2023. Levered free cash flow margin has also reached a new level since 2020. It is encouraging to see that ResMed has consistently delivered a levered free cash flow margin above 30% in the past three years. Free cash flow yield has dropped to its lowest level in fiscal 2023. However, it is important to note that this data is based on when ResMed reported earnings. It could have changed since then.

Another important aspect to consider is the level of debt. It is crucial to determine whether a business has a manageable debt that can be repaid within a three-year period. This can be assessed by calculating the ratio of long-term debt to earnings. After performing the calculation on ResMed, I have determined that the company has a debt-to-earnings ratio of 1,59 years, which is below the limit of 3 years. Hence, debt is not an issue for ResMed.

Like any other investment, there are risks associated with investing in ResMed. One risk is the introduction of obesity drugs. The introduction of obesity drugs has made the market nervous about ResMed's future. The reason is that studies have shown that sleep apnea is present in approximately 77% of patients with obesity, approximately 76% of patients with chronic heart failure, and approximately 72% of patients with type 2 diabetes. Thus, if these new obesity drugs lower the number of patients with any of these diseases, there may be less need for ResMed devices in the future. ResMed's management conservatively estimates that obesity drugs will reduce the number of people with sleep apnea, chronic obstructive pulmonary disease, or respiratory insufficiency from 1,4 billion to 1,2 billion in 2050. However, there are still many unknowns regarding the effects that obesity drugs will have. Macroeconomics. Macroeconomic factors, such as high inflation, affect ResMed. ResMed has more than 10.000 employees worldwide, which means that wage inflation will affect ResMed. The high inflation has also increased the costs of components, which has further affected ResMed. Hence, the increase in component and manufacturing costs has resulted in lower profit margins. Gross profit margins have decreased since fiscal 2021, when the gross profit margin reached 59,1%. In fiscal 2022, the gross profit margin decreased to 57,7%, while in fiscal 2023, it further decreased to 56,5%. If we continue to experience high inflation, it will impact profitability in the future. Competition. In their annual report, ResMed mentions that the global competition for the sales of their products and services is intense. Their primary competitors are Philips and Fisher & Paykel. As Philips had to recall their respiratory products, ResMed have benefited from Philips' losses. Philips has resumed the sale of respiratory devices, which may lead to increased competition in the future. Furthermore, ResMed also competes with surgical procedures, and the development of new innovative procedures could render their products obsolete or noncompetitive.

There are also numerous reasons to invest in ResMed. A large addressable market. There are over 2 billion people worldwide suffering from sleep apnea, chronic obstructive pulmonary disease, respiratory insufficiency due to neuromuscular disease, and insomnia. While not all of them require devices, ResMed believes that they have a significant opportunity ahead of them. The reason is that their end markets remain significantly underpenetrated, offering numerous opportunities to enhance value, minimize obstacles, reduce costs, and enhance patient outcomes. Furthermore, management believes there is a long-term need for their products. During an earnings call, they stated, "There is a huge number of people needing our sleep apnea treatment solutions today and for the next two to three decades and beyond." The Mask and Other Business. The Mask and Other Business is a great venture for ResMed, as it offers high profit margins and serves as an additional source of income for the company. It continues to grow at a double-digit rate. Once a person owns a ResMed device, they will need to replace parts. For instance, mask cushions should be replaced monthly, mask frames every third month, and mask headgear every six months. Thus, the more devices ResMed sells, the greater the need will be for replacement parts. Thus, it is expected that this business will continue to grow in double digits. SaaS Business Growth. Management has mentioned that the SaaS business remains an integral part of ResMed's growth strategy. They believe that it will deliver value for customers and drive long-term sustainable growth for shareholders. So far, the SaaS business has experienced high single-digit organic growth. However, management believes that growth will pick up and has mentioned that they see a pathway to stable double-digit organic growth across the SaaS business, as well as an increase in net operating profit performance from this segment of the business.

Now it is time to calculate the price of shares in ResMed. I perform three different calculations that I learned at a Phil Town seminar. The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 6,09, which is from fiscal year 2023. I have selected a projected future EPS growth rate of 10,4%. (Management expects an average 10,4% growth until 2026). Additionally, I have chosen a projected future P/E ratio of 20,8, which is twice the growth rate. This decision is based on the fact that ResMed has historically had a higher P/E ratio. Lastly, our minimum acceptable rate of return is already set at 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $84,22. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy ResMed at a price of $42,11 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is called the Ten Cap price. The rate of return that an owner of a company (or stock) receives on the purchase price of the company is essentially its return on investment. The return should be at least 10% annually, and I calculate it as follows: The operating cash flow last year was 935 and capital expenditures were 142. I attempted to review their annual report to determine the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated for maintenance purposes. This means that we will use 99 in our calculations. The tax provision was 204. We have 147,085 outstanding shares. Hence, the calculation will be as follows: (935 – 99 + 204) / 147,085 x 10 = $70,70 in Ten Cap price.

The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With ResMed's Free Cash Flow Per Share at $5,54 and a growth rate of 10,4%, if you want to recoup your investment in 8 years, the Payback Time price is $70,97.

I believe that ResMed is a great company with effective management. I like this business because they not only profit from selling a device, but they also continue to profit from it as patients will need to replace parts. Furthermore, their SaaS business is growing, which will also generate recurring revenue. Like all other companies, ResMed is facing some risks. Macroeconomics has put pressure on margins, but I believe this is only temporary. Competition will always be a factor, but ResMed has benefited from Philips' mistakes. The question now is whether customers will trust Philips again in the near future. The biggest risk is obesity drugs. It is hard to predict the effect that they will have on ResMed, and while management is optimistic, the stock market reaction was less optimistic as ResMed lost 30-40% of its market cap in 90 days. Hence, the progress of obesity drugs is something that needs to be monitored. Overall, I find ResMed to be an intriguing company. I don't believe that obesity drugs will have a significant impact on their business in the near future, and there is potential for long-term growth. I don't believe that ResMed will be trading at a 50% discount to its intrinsic value, but I would still like to see some discount to intrinsic value due to the uncertainty surrounding obesity drugs. Hence, if I can get a 20% discount on the intrinsic value of the Payback Time price and Ten Cap price, I will open a position. It means that I will buy ResMed stocks if they drop to $113.

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