We maintain our $39 fair value estimate for narrow-moat ResMed (ASX: RMD), following second-quarter fiscal 2024 results. Despite significant market pessimism given the growing prevalence of GLP-1 drugs for weight loss, underlying earnings before interest and taxes (“EBIT”) grew 15% to $366 US million sequentially on first-quarter fiscal 2024, with sales up 5% and the underlying EBIT margin expanding roughly 250 basis points to 31%.

Our long-term estimates are broadly unchanged, but we increase our fiscal 2024 underlying EBIT forecast by 2%. This was largely due to expenses tracking slightly below our expectations, as well as strong performances in ResMed’s software-as-a-service business and device sales outside the Americas, up 16% in constant currency on the previous corresponding period.

Shares remain materially undervalued. Improving patient flow and availability of devices continue to support strong sales. We also anticipate margin expansion as ResMed’s sales mix shifts to higher-margin masks, and cost inefficiencies of simultaneously ceasing production of its older AirSense 10 devices. Our midcycle 34% EBIT margin forecast is unchanged.

The second-quarter gross margin expanded 90 basis points sequentially to 57% versus the first quarter, driven by product price increases and reduced freight costs. In addition, selling, general, and administrative (“SG&A”) expenses and research and development expenses decreased to 19.1% and 6.4% of revenue in the second quarter versus 20.2% and 6.9% in the first quarter, respectively.

This is largely a result of the firm reducing its global workforce by 5% in October 2023, largely in noncore SG&A activities, and instead planning to invest more in product innovation and increasing brand awareness. We think this a sound strategy to help further penetrate the market.

Business strategy

ResMed is taking a “smart devices” and Big Data approach to further entrench itself as one of the two leading players in the global obstructive sleep apnea, or OSA, market. With cloud-connected devices, physicians can monitor patient compliance and encourage continued use. Higher adherence supports both reimbursement rates from payers and the resupply of masks and accessories.

ResMed also plays a key role in producing clinical data that demonstrates treatment can minimize related risks such as hypertension, stroke, heart attack and Alzheimer’s disease. Through its own testing devices and education, ResMed seeks more widespread diagnosis and treatment of OSA.

The global OSA homecare device market, is a two-player duopoly with over 80% estimated market share split between ResMed and Philips, with ResMed the market leader in the majority of the 140 countries it competes in.

The market offers a large global growth opportunity as penetration within developed markets is estimated at one fifth of the roughly 15% prevalence, and emerging markets are essentially untapped. In the U.S., we estimate roughly half of the 22 million people diagnosed with OSA are treated with continuous positive airway pressure, or CPAP, with another 34 million remaining undiagnosed. ResMed operates in over 140 countries with over 900 million people estimated to have sleep apnea globally, indicating the long runway for growth.

Moat rating

We award ResMed a narrow moat rating based on switching costs and intangible assets, which have helped the company achieve high customer adherence rates and above-average industry growth.

In fiscal 2020, both ResMed and Philips reported selling over 10 million total cloud-connectable medical devices globally to date. In fiscal 2021, ResMed crossed the 15 million mark. These newer-generation devices enable physicians to remotely monitor the patient’s usage and breathing performance, entrenching ResMed as a preferred provider with all three users of the data. For the patient, the device feedback encourages usage and allows them to get individualized care from the physician, leading to better clinical outcomes. For the physician, trust in recorded data and grown familiarity with the software is likely to reduce switching to a different provider. For the payor, evidence of patient compliance informs continued reimbursement support.

The duopolistic nature of the market is also in the best interest of durable medical equipment, or DME, suppliers as it limits the number of device manufacturers they deal with. These factors have contributed to ResMed reporting up to 87% adherence rates when the physician is using its cloud-based patient monitoring system, AirView, compared with the estimated industry average adherence rate of 50%. A higher adherence rate benefits both device upgrades as well as masks and accessories revenue as the physician reminds the patient of when they should be replaced.

ResMed typically earns 40% of group revenue from the resupply of masks and accessories. Although these are interchangeable with other brands, competitors would be challenged to offer original products that are comparable in quality and comfort without infringing on ResMed’s plethora of patents, while also having to compete with its entrenched relationships.
ResMed’s intangible assets, namely its brand and patent portfolio, have also contributed to above-average industry growth and helped maintain its commanding market share. ResMed typically spends roughly 7% of revenue on research and development each year, which has ensured consistent product launches.

Despite growing off a much smaller base, Fisher & Paykel’s competing homecare segment has a trailing five-year revenue compound annual growth rate (“CAGR”) of 5%, lagging ResMed’s 10% over the same period. We think ResMed’s intangible brand has also enabled significant price premiums over less well-known peers.

While Philips and ResMed are comparatively priced, we estimate ResMed’s pricing to be roughly 15% higher than the remaining peer average across the automatic positive airway pressure device category and 30% higher in the CPAP category. This may reflect higher reimbursement support. In addition, we think ResMed’s patent portfolio of over 8,200 granted or pending patents, will likely assist ResMed in maintaining its market share with less than one third expiring in the next five years.

Due to its significant market share and high gross margins in a structurally growing industry, ResMed has posted an average return on invested capital, or ROIC, of 20% over the last decade. We anticipate the company’s ROIC to far exceed its weighted cost of capital of 7.4% over our explicit forecast period, even in our bear-case scenario.