James Gruber: Sleep apnea device maker ResMed (ASX:RMD) share price has taken a beating of late, thanks to the hype around drugs that supposedly cure obesity. If right, it could impact the demand for sleep apnea devices. It's a good time to catch up with Shane Ponraj, Morningstar's analyst, to discuss the latest developments.

Shane, thanks for your time today.

Shane Ponraj: No worries. Thanks, James.

Gruber: Worries about the effectiveness of new weight loss drugs and the potential impact on sleep apnea device demands seem to be behind ResMed's share price fall. First, can you tell us about these weight loss drugs?

Ponraj: Yeah, sure. So, the class of drugs we're talking about are GLP-1 drugs. So, some of the brand names you might have heard of are Ozempic and Wegovy. And these drugs have been around for a while and traditionally, they've been used to treat type 2 diabetes. But it's found that these drugs are also quite good at weight loss. And Wegovy around two years ago was first approved officially for this indication.

So, just as a background, GLP-1 is a hormone that our bodies produce in response to food. So, when we eat food, our blood sugar rises. But when our body senses GLP-1, our pancreas produces insulin and suppresses glucagon, which helps to bring back the blood sugar down. So, for people with diabetes, this is really important because elevated blood sugar can do all sorts of damage to arterial walls and increase the risk of serious health complications. And for weight loss, GLP-1 actually slows down how quickly food passes through our body and our brain also suppresses our hunger and our appetite. So, basically, we essentially feel fuller for longer on a lower amount of food.

Gruber: And how effective are these drugs when it comes to weight loss?

Ponraj: Yeah. So, these drugs are quite effective for diabetes and also for weight loss. The average weight loss is around 15% and typically, it's administered by injectables on a weekly basis. But it's reasonable to assume that as supply improves, there will be an oral version of this drug that will be quite accessible in the future, but that should take some time.

Gruber: How could these drugs impact the sleep apnea market?

Ponraj: So, the thinking here is that if most sleep apnea patients are obese and these drugs solve obesity, then for the most part, they should solve sleep apnea as well. But it's important to remember that obesity is just one risk factor of sleep apnea. A lot of it is anatomical, so the jaw end where the tongue sits and sometimes also central, so brain related, and obesity just worsens this by constricting the airway more.

Gruber: Are the weight loss drugs a real threat to ResMed then, in your view?

Ponraj: Look, it's reasonable to assume some sort of impact, but we think that's more than priced in now. Basically, we think the global sleep apnea market is untapped and largely under-penetrated and more than big enough for ResMed to remain a meaningful player in addressing sleep apnea. So, sleep apnea patients might be obese on average, but those who take the drugs after they lose 15% of body weight, many of them will still be technically obese. And close to all of these patients who are on the drugs, it won't solve their sleep apnea completely, but it would rather have a proportionate drop in the number of episodes or the amount of times that the airway is obstructed when they sleep. So, someone who has severe sleep apnea might move down to moderate sleep apnea, but they would still greatly benefit from being on a CPAP machine.

Gruber: So, these latest developments don't change your view much on ResMed's outlook for the next 12 to 24 months?

Ponraj: No. We think these drugs will continue to have little to no impact on ResMed in the near term. ResMed is still delivering really strong top-line growth, and we think what's more likely is that the market will realize that these drugs will take some time to be widely adopted and more than that for it to flow through into ResMed's financials. So, some of the factors that we see limiting widespread adoption is cost. So, these drugs aren't widely reimbursed yet. Supply – so, even now, a lot of people with diabetes are struggling to get access to these drugs. And third is patient adherence. So, side effects are minor, but still very common in terms of nausea, vomiting, diarrhea. And you have to also ask yourself what would happen to people who come off the drugs. Will they put the weight back on? In terms of ResMed's revenue in the near term, they're still dominating the industry. Their main competitor, Philips, is still out of the market. Sleep apnea diagnosis rates are continuing to recover and improve. And in terms of their supply constraints that they experienced during the pandemic of chip shortages, that's pretty much behind them now.

Gruber: So, I assume then that ResMed's economic moat remains unchanged?

Ponraj: Yeah, we retain our narrow moat for ResMed. If anything, ResMed's moat has strengthened since Philips' recall. So, physicians are more often prescribing ResMed's products now to new patients who are then entrenched into the ResMed ecosystem. ResMed boasts the highest adherence rates in the industry of 87% and their devices and masks are only getting better with time in terms of being smaller, quieter, more comfortable. So, they are the number one player in the market for a reason.

Gruber: Your fair value on the stock is $39. It offers a lot of upside from here. How do you derive that price target?

Ponraj: Yeah. So, our forecasts on the revenue line are quite in line with consensus. I think the biggest driver of why we're different is that we're forecasting EBIT margins to expand a bit to 34% in five years from about 31% in fiscal '21. EBIT margin is around 29% currently, but near-term, we think the sales mix should shift to higher-margin masks and accessories. Cost inefficiencies of manufacturing both the A10 and the AirSense 11 device that should stop once the company focuses on the AirSense 11 and the full benefits of freight, and component costs coming down, that's yet to fully flow through to the P&L. And longer-term, we think SG&A costs will continue to scale as they have done in the past. And we think that's a reflection of the growing evidence for sleep apnea and that being more widely understood.

Gruber: Thanks for your time, Shane.

Ponraj: No worries. See you in time, James. Thanks.