Regulatory Overhaul Implies 30% Downside For ResMed Stock

Short interest in ResMed Inc. RMD is at its highest point this year, signaling that investors are growing increasingly bearish on the company's valuation and are betting on a decline in the price per share. This marks the biggest bet bears have made against the company since ResMed traded at a new 52-week high last July. Shares of the company then slid more than 27%, marking a 52-week low, just four weeks later (as depicted, below).

Insider stock sales dually suggest the market may have topped, with board members and members of management selling 1.31MM shares in aggregate in the last 12 months -predominately in the low to mid-$30 range. 

Notwithstanding, ResMed trades at a sharp premium to valuations underscoring mature mid-tier medical technology companies. Valued at 20X trailing twelve month earnings versus 12X trailing EPS typical in their segment implies that investors are expecting sharp growth. Analysts and industry experts, however, are suggesting the opposite. 

In September, the Centers for Medicare and Medicaid Services (CMS) will institute a second round of cuts or 'competitive bidding program' to reduce reimbursement for CPAP (continuous positive airway pressure) treatments. The first round of cuts affected 9 metropolitan areas, where average Medicare payment rates for CPAP were lowered by 34%. The second round of the competitive bidding program will affect another 91 metropolitan areas, with consensus calling for reimbursement cuts of 30% or more. 

ResMed is a major manufacturer of airflow generator equipment based on CPAP  therapy, which is designed to deliver pressurized air through a nasal mask to prevent collapse of the upper airway during sleep, for patients with sleep apnea. Though CMS reimbursement cuts for this therapy will inevitably affect ResMed's future earnings, our financial models show FY2013 earnings lower by 10%; 15% in FY2014. This implies soft growth and contraction of ResMed's price-to-earnings multiple in the near future. 

According to Reuters, at least 7 analysts have revised estimates lower for FY2013 and FY2014 in the last 4 weeks. Analysts who expected double digit growth now forecast sales growth of 8.76% in 2013, on average. If earnings for this year are in line with current estimates, growth will still have slowed to 13% year-over-year, down from 17% one year ago. Depending on the severity of CMS cuts, further revisions to the downside could be inevitable with downgrades likely following suit. 

Government spending cuts can severely impact a company's financial performance, even if the cuts appear marginal, nominally. Case in point, nursing homes such as Skilled Healthcare SKH and Sun Healthcare SUNH tumbled more than 60% when CMS cut reimbursement by 11.1% one year ago. Lincare Holdings LNCR, a provider of oxygen, respiratory, and other services to patients at home reported a 35% decline in EPS from 2008 through 2009 due to a 15% reduction in reimbursement caused by Medicare's 36-month oxygen cap, as well as a 9.5% DME cut, both of which took place in early 2009. 

ResMed's customers, distributors of durable medical equipment (DMEs) and home health equipment (HMEs) are anticipating deep cuts to reimbursement. A survey by VGM Group, a buying group for DMEs, indicated a Round 2 competitive bidding discount for CPAP products of ~28%. Lincare, the largest DME distributor, recently announced supply chain initiatives including vendor consolidation and lower pricing to offset reimbursement cuts - a strategy that other DMEs are likely to follow. This shows that the DMEs and HMEs will likely look for concessions from their suppliers (i.e. ResMed) to offset losses in revenues. 

More concerning, another rule proposed by the CMS, which goes into effect in early August, will inhibit ResMed's fastest-growing product - disposable masks sold with CPAP equipment. As shown in the table (below) 'masks and other accessories' accounted for well over half of ResMed's top line growth last quarter.

As the so-called 'blades' in ResMed's razor-and-blades model faces a regulatory hurdle that could blanket sales growth, the company's gross margins could see their largest contraction in years. The new rule states that DMEs can only provide a replacement mask when the original item is no longer able to function, and documentation of the dysfunction is required. Previously, DMEs were simply required to document when a patient's mark was 'approaching exhaustion' to replace with another. It's clear that the CMS is looking closely at this treatment segment for greater efficiency and cost savings, which translates directly to lower profits for the company. 

Even by conservative estimates, if FY2013 earnings are 10% lower than consensus is currently calling for, ResMed is fairly valued at $21.60 a share, which implies a downside of more than 30% from recent market prices. This assumes that FY2013 EPS come in at $1.80. 

Yet, the impact that regulatory changes will have on ResMed's earnings have largely been discounted by analysts covering the company. In addition to painful reimbursement cuts and meticulous changes that will impact disposable mask sales, ResMed could be faced with a reversal or gross impediment in growth as its leading market share has become a point of vulnerability. Feltl & Co. downgraded the stock based on a study of the CPAP landscape, which included competitive market data for masks and air-flow generators. Names like Respironics (now owned by Phillips BV), DeVilbiss (a division of Sunrise Medical Inc.), and Fisher & Paykel Healthcare Corporation will further pressure ResMed's margins as they compete for share in the CPAP market. Because they are private, these names have largely dodged analysts' radars. Importantly, the largest of these names, Respironics, is readying the launch of a new line of CPAP products that will directly compete with ResMed's offering. 

Lastly, there remains another material concern that could be detrimental to ResMed's future earnings. To understand why this factor is a concern, it's important to take a step back and explain the loophole the CMS discovered, which then prompted the competitive bidding program. As it happens, CPAP products fell in a segment where government reimbursed at a rate roughly 30% higher than private insurers. When they discovered this, they formulated a plan to drop reimbursement to match rates offered by private insurance companies.  But what few have considered is the not-so-unlikely event that private insurers will, in turn, pressure CPAP manufactures like ResMed to maintain the discount to CMS reimbursement historically enjoyed by these insurers. The outcome, then, is a far bleaker outlook than any analysts have suggested.    

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