Applied Portfolio Management Analysts: Zhiqiang Lu and Scott Wells Report Date: 5/12/2014 Market Cap (mm) $6,730 Annual Dividend $0.84 2‐Yr Beta (S&P 500 Index) 0.81 Return on Capital 19.0% Dividend Yield 1.8% Annualized Alpha 10.4% Compared With: EPS (ttm) $2.28 Price/Earnings (ttm) 20.6 Institutional Ownership 14.4% Edwards Lifesciences Corp. Current Price $47.08 Economic Value‐Added (ttm) $181 Short Interest (% of Shares) 25.3% Teleflex Incorporated 12‐mo. Target Price $48.50 Free Cash Flow Margin 21.9% Days to Cover Short 30.9 and the S&P 500 Index Business Description Total Revenue 11.5% Free Cash Flow 53.3% EBIT 16.0% Total Invested Capital 11.0% NOPAT 19.5% Total Assets 10.8% Earnings Per Share 19.5% Economic Value‐Added 27.0% Dividends Per Share N/A Market Value‐Added 9.1% 2009 2010 2011 2012 2013 21.0% 22.3% 21.7% 21.5% 25.1% 13.4% 11.6% 16.9% 23.5% 21.9% 3.7% 3.6% 5.9% 4.2% 4.6% 0.0% 0.0% 0.0% 0.0% 1.4% 2009 2010 2011 2012 2013 0.97 1.26 1.49 1.75 2.15 0.00 0.00 0.00 0.00 0.68 0.93 1.18 1.32 1.55 2.12 0.13 0.46 (1.14) 1.54 1.76 Datasource: Capital IQ Margins and Yields Operating Margin Per Share Metrics Earnings NOPAT Free Cash Flow Dividends Free Cash Flow Margin Earnings Yield Dividend Yield ResMed Inc., through its subsidiaries, engages in the development, manufacture, and distribution of medical equipment for treating, diagnosing, and managing sleep‐disordered breathing and other respiratory disorders. It offers various products, including airflow generators, diagnostic products, mask systems, headgear products, and ventilation devices for the treatment of sleep‐disordered breathing that includes obstructive sleep apnea and other respiratory disorders, as well as other optional accessories, such as cold passover humidifiers, carry bags, and breathing circuits. The company also Investment Thesis ANNUALIZED 3‐YEAR CAGR ResMed (RMD) is a leading developer, manufacturer and distributor of medical equipment for treating sleep‐disordered breathing (SDB) and other respiratory disorders. RMD operates in an industry that is expected to achieve robust growth in the coming years and is well positioned as an industry leader to take advantage of this expected growth in the U.S. and abroad. Total revenues, EBIT and NOPAT have all shown steady increases since 2008. ResMed has generated strong free cash flows from last two years, with a superb ROIC of 19% and with a corresponding WACC of 7.7% for 2013. Using conservative forecasting assumptions, ResMed is currently under‐valued in the market, based on the present value of FCF. ResMed Inc. Sector: Healthcare BUY RMD ‐5% 0% 5% 10% 15% 20% 25% 30% RMD ^SPX ‐30% ‐20% ‐10% 0% 10% 20% 30% 40% RMD EW TFX 0 10 20 30 40 50 60 2008 2009 2010 2011 2012 2013 Price/Earnings Price/Free Cash Flow $0 $50 $100 $150 $200 $250 $300 $350 $400 2008 2009 2010 2011 2012 2013 EBIT Net Operating Profit After Tax $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $0 $50 $100 $150 $200 2008 2009 2010 2011 2012 2013 Economic Value‐Added Market Valued‐Added 0% 5% 10% 15% 20% 25% 2008 2009 2010 2011 2012 2013 ROA ROE ROIC
and ventilation devices for the treatment of sleep‐disordered
breathing that includes obstructive sleep apnea and other respiratory
disorders, as well as other optional accessories, such as cold passover
humidifiers, carry bags, and breathing circuits. The company also
Investment Thesis
ANNUALIZED 3‐YEAR CAGR
ResMed (RMD) is a leading developer, manufacturer and distributor of
medical equipment for treating sleep‐disordered breathing (SDB) and
other respiratory disorders. RMD operates in an industry that is
expected to achieve robust growth in the coming years and is well
positioned as an industry leader to take advantage of this expected
growth in the U.S. and abroad. Total revenues, EBIT and NOPAT have
all shown steady increases since 2008. ResMed has generated strong
free cash flows from last two years, with a superb ROIC of 19% and
with a corresponding WACC of 7.7% for 2013. Using conservative
forecasting assumptions, ResMed is currently under‐valued in the
market, based on the present value of FCF.
ResMed Inc. Sector: Healthcare BUYRMD
‐5%
0%
5%
10%
15%
20%
25%
30%RMD ^SPX
‐30%
‐20%
‐10%
0%
10%
20%
30%
40%RMD EW TFX
0
10
20
30
40
50
60
2008 2009 2010 2011 2012 2013
Price/Earnings Price/Free Cash Flow
$0
$50
$100
$150
$200
$250
$300
$350
$400
2008 2009 2010 2011 2012 2013
EBIT Net Operating Profit After Tax
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$0
$50
$100
$150
$200
2008 2009 2010 2011 2012 2013
Economic Value‐Added Market Valued‐Added
0%
5%
10%
15%
20%
25%
2008 2009 2010 2011 2012 2013
ROA ROE ROIC
NYSE: RMD
Analysts: Zhiqiang Lu and Scott Wells Student Investment Fund Portfolio
Business Description
ResMed (RMD) is a leading developer, manufacturer and distributor of medical
equipment for treating, diagnosing, and managing sleep-disordered breathing (SDB)
and other respiratory disorders. Sleep-disordered breathing is most commonly
associated with obstructive sleep apnea (OSA). Since forming in 1989, RMD has
revolutionized the treatment of OSA and SDB through the development of CPAP,
airflow generators, diagnostic products, mask systems, headgear and other
accessories. RMD’s growth has been fuelled by global expansion, increased
awareness of respiratory conditions as a significant health concern among physicians
and patients, and research and product development efforts.
Recommendation: BUY Market Cap: $7 billion Current Price: $49.75
Sector: Health Care Dividend Yield: 2.0% 12-month target price: $48.50
Sub-Sector: Equipment P/E Ratio: 21.83 Beta: 0.73
Highlights
RMD is well positioned as
an industry leader to take
advantage of expected
sector growth in the U.S.
and abroad.
RMD’s total revenue, EBIT
and NOPAT have steadily
increased over the last 5
years.
Since 2008, RMD has
steadily increased EVA and
MVA.
Using conservative
forecasts, RMD expected to
generate a value spread in
excess of 7.5%.
At a current price of $49.75
and an intrinsic value of
$56.28, RMD is undervalued
by approximately 11.6%.
Investment Thesis
ResMed is a leading developer, manufacturer and distributor of medical equipment for treating sleep-disordered
breathing (SDB) and other respiratory disorders. RMD operates in an industry that is expected to achieve robust
growth in the coming years and is well positioned as an industry leader to take advantage of this expected growth in
the U.S. and abroad. ResMed has generated strong free cash flows from last two years, with a superb ROIC of 19%
and with a corresponding WACC of 7.7% for 2013. Using a conservative forecasting approach, ResMed is currently
under-valued in the market, based on the present value of FCF.
NYSE: RMD
Macroeconomic Outlook
Our February review of the 21 Conference Board
Economic Indicators, leads us to believe that the
economic expansion will pick up steam in 2014.
Strong leading indicators such as new
manufacturing orders, nominal and real durable
goods orders, and the S&P 500 index all point to
increasing economic activity and optimism for the
future. Additionally, initial unemployment claims
have fallen to near their pre-recession levels as the
economy continues to recover and put people back
to work. For the all-important first quarter of the year, distinctly risk-off sectors provided highest
returns best returns as measured by SPDR sector ETF’s. Health Care was a particularly strong sector for
Q1 generating total returns of 6.1%. While the advance estimate of GDP for the first quarter of 2014
was disappointing indicating a rise of only 0.1%, we remain confident in our forecast for the remainder
of the year.
Industry Outlook
RMD operates in an industry that is expected to achieve robust growth in the coming years. This growth
is attributable to increased public awareness SDB and its relationship with other serious health disorders
such as type 2 diabetes and congestive heart failure. A 2013 study estimates that 26% of adults
between the ages of 30 and 70 have some form of OSA. This represents approximately 46 million
people in the United States. Industry experts believe that the global respiratory devices market could
grow to $7.1 billion by 2017 which would be a compound annual growth rate (CAGR) of 7%. The U.S.
market is expected to reach $4 billion by 2017, an 8% CAGR.
RMD is well positioned as an industry leader to take
advantage of this expected growth in the U.S. and abroad.
RMD markets its products in approximately 100 countries
with sales outside of North and Latin America representing
approximately 44% of their 2013 revenues. In a recent Q3
2014 earnings call, RMD announced that revenue from
outside the Americas had grown 6% on a constant currency
basis from the prior year.
2013 Revenues by Geographic Segment
NYSE: RMD
Historical Analysis
3YR Compound Average Growth Rates
Analyzing the three year CAGRs shows that RMD’s total revenue, EBIT, and NOPAT have all experienced
superior growth in excess of 10%. We also see that RMD’s EPS grows even faster than revenues or EBIT,
which indicates the firm gains additional efficiencies in the interest and tax sections of the income
statement. EVA and MVA also show strong growth. In 2013, RMD began to distribute profits to
shareholders in the form of a cash dividend equal to $0.68 per share. Total invested capital and total
assets have experienced almost equal CAGR’s, indicating much of the growth in assets is attributed to
property, plant, and equipment and other components of invested capital. FCF expands very fast at a
growth rate of 53.3%, which shows solid fundamentals.
Performance Analysis
Total Revenue and Net Income: RMD has shown
steadily increasing revenues each year, including
those years attributed to the “great recession”.
Top-line revenue growth that is increasing means
the reservoirs of gross cash from which accounting
and economic profits are created are also
increasing.
NYSE: RMD
EBIT and NOPAT: RMD’s EBIT and NOPAT have also
increased each year since 2008. This shows that the
increasing revenues RMD has enjoyed have passed
through the income statement and resulted in increased
operating profits.
Free Cash Flows: As RMD has increased its NOPAT, free cash flows have also generally trended
upwards. The one exception is 2011 when NOPAT increased from 2010, but free cash flows suffered a
substantial drop and were negative for the year. This is attributed to both a small increase in net fixed
assets along with a substantial increase in working capital for the year.
Profitability: ROA, ROE and ROIC have all been
trending upwards since 2011. While all three
measures suffered a small decline in 2011, the
brief drop can be explained due to a sharp
increase in total invested capital in 2011. Such an
increase is a strong sign of asset expansion as net
fixed assets also increased that year.
NYSE: RMD
Key Forecasting and Modeling Assumptions
The valuation of RMD was performed using modeling consumptions that were conservative in order to
remain consistent with the outlook of the portfolio. A number of approaches are available to estimate
the intrinsic value of a company. One such approach, known as the dividend discount model, involves
forecasting the future dividends of the firm and then discounting them back to the present value.
Because RMD has only just begun to distribute a cash dividend since 2013, not enough information was
available to provide a reliable forecast of future dividends. As such, a discounted free cash flow model
was used to estimate the RMD’s intrinsic value. At a current price of $49.75 and a per share intrinsic
value of $56.28, RMD is undervalued by 11.6%. The modeling assumptions and intrinsic value estimates
are further explained below.
Income Statement Inputs
Revenue Growth: Revenue growth from 2009 has consistently remained above 10% reaching a high of
18.6% in 2010. This results in a 5 year average of 12.6% from 2009 through 2013. In July of 2013,
Medicare and Medicaid Services instituted a second round of reimbursement cuts for CPAP devices,
masks and accessories. This second round of cuts resulted in a 47% reimbursement reduction. The
revenue forecast for 2014 is for a 4.4% increase while RMD works to absorb these reimbursement
reductions. The growth rate was then increased back up to 7% in 2015, which remains well below the 5
year average. Revenues were then tapered down to a long-term rate of 3.5% in 2018 and beyond.
Year 2014E 2015E 2016E 2017E 2018E
Revenue Growth 4.4% 7.0% 6.0% 5.0% 3.5%
Gross Margin: From 2009 through 2013, RMD’s gross margin remained stable around an average of
60.4%. Analysts at S&P’s Capital IQ reported that gross margins were expected to expand in 2014 due to
improved manufacturing and a more profitable sales mix. To remain conservative, a small expansion of
gross margin to 61% was used in the forecasts.
Operating Margin: From 2009 through 2012, RMD’s operating margin remained relatively stable and
fluctuated around an average of 21.6%. 2013 saw an expansion of this margin to 25.1%, which then
raised the overall 5 year average to 22.3%. Because operating margin feeds directly into EBIT and
NOPAT, and ultimately then into free cash flows, the forecasts made here will have a dramatic effect on
the final intrinsic value of the firm. In order to remain conservative in the final intrinsic value estimates,
NYSE: RMD
an operating margin of 21% was used in all forecasted years. The 21% margin represents the lowest
such margin RMD has achieved since 2009 and we believe is an appropriately conservative estimate
going forward.
Net Margin: Net margins from the previous 5 years expanded moderately from 15.9% in 2009 to 20.3%
in 2013. This resulted in a 5 year average of 18.1%. To account for Medicare and Medicaid
reimbursement cuts in 2013, the net margin in 2014 was forecasted to drop to 17.4%. For 2015 and all
remaining years, the average of 18.1% was used.
Common Shares Growth: In February of this year, RMD’s board of directors authorized a new share
repurchasing program allowing the company to acquire as much as an aggregate of 20 million shares of
ResMed, Inc. stock. This share repurchase program has no expiration date. Since 2009, RMD has seen
common share growth rates of -2.3%, -0.2%, 1.0% (positive), -4.3% and -2.0%, respectively. To account
for the share repurchase program we forecasted a growth of -2.0% for all forecasted years. This was
slightly higher negative growth than the previous 5 year average of -1.6%.
Dividend Growth: RMD first began issuing a cash dividend in 2013 at $0.68 per share. It then raised the
dividend by 47% in 2014 to an even $1.00 per share. Without further guidance as to what the firm’s
future dividend policy might be, our forecasts did not include any increases for 2015, 2016 or 2017. We
did include a modest dividend increase of 3.0% for 2018 and all future years thereafter.
Balance Sheet Inputs
Cash and cash equivalents: For the years 2009 through 2013, ResMed’s cash and cash
equivalents average as a percent of sales is 53.2%. This average is elevated due extremely high
levels of cash and equivalents in 2011, 2012 and 2013 where the percentages were 59.1%, 59.2
and 57.8, respectively. We believe that the cash to sale ratio in excess of 50% is too high and
that the company will decrease its cash and equivalents to a more normalized level. Therefor
we have tapered down our forecast from 53% in 2014 to 40% in 2018 and all future years.
Receivables: We see total receivables are stable around the historical average, which means it
is appropriate to leave it unadjusted in the forecast at 22.0%.
Inventory: Although inventory has been trending down significantly from 16.2% in 2011 to 9.6%
in 2013, we would like more remain a little conservative and therefore have increased it slightly
from 2013 to 10% for all forecasted years.
NYSE: RMD
Total current assets: Since 2011, total current assets have decreased from 104% of sales to
95.7%. Because of the decrease of revenue growth projected in 2014, we have also decreased
the total current assets ratio to 95% for that year. The remaining forecasted years use a rate of
99.7% which is the previous three year average.
Net PP&E: Over the previous 5 years, ResMed has been able to decrease their Net PP&E as a
percent of sales. In 2001, Net PP&E represented 41% of sales as of 2013 that number has
dropped to 27.2%. Because of increasing of R&D expenditure, we believe the 5 year average of
34.5% is appropriate for all years of our forecast.
Total assets: Due to increasing of Net PP&E as explained above, we provided for a modest
increase to total assets up to 157%. This is less than 1% above the previous 5 year average of
156.3%
Accounts Payable & Current liabilities: These are stable around the historical average of
11.4%, which means it is appropriate to leave it unadjusted in the forecast.
Total Debt: ResMed will repay all long-term debt principal in 2014. There is no evidence to
show ResMed will issue new debt, however we still would like to remain more conservative and
therefore have forecasted total debt at 8% for all forecasted years.
Total Equity: In recent years, total equity has been on a down trend from a level of 139.2% in
2011 to 106.3% in 2013. Because of ResMed’s common stock repurchase program, we have
further decreased it to 100% for our forecast.
NYSE: RMD
Value Creation
EVA
EVA measures the true economic profit generated by the firm. A firm produces economic profit
when the operating profits generated exceed the costs of all capital invested in the business
including equity and debt. As such, the drivers of EVA are a form of accounting profit and the
cost of capital. As the gap between the two drivers grows, more EVA is being generated. RMD
has consistently maintained a profit
margin (measured here as EBITDAR
Margin) in excess of 35% while its capital
costs as a percentage of sales have drifted
downward. This widening gap is a good
sign that the company is generating
economic profit by successfully managing
expenses and maintaining a low cost of
capital.
MVA
MVA measures the wealth a company has created for its shareholders. This wealth is the
difference between the market value of the firm and the total invested capital in the business.
Compared below with EVA, we can see that
both have been trending upwards since
2009. As the graph shows, there was a
small decrease in EVA in 2011. That same
year, the MVA experienced its own slide
when the P/E ratio dropped from 27.5 in
2010 to 17.1 in 2011.
NYSE: RMD
Weighted Average Cost of Capital (WACC) Assumptions In order to determine RMD’s cost of capital, the risk-free rate was set at 2.678%, the 5-Yr Beta was
smoothed to 0.83 and the market risk premium was set at 6.0%. This yielded a CAPM cost of equity of
7.658% and, since RMD’s uses very little debt, a WACC of slightly less than 7.7%.
Value Spread
As was explained previously, RMD has shown the ability to consistently create economic value through
increasing profits while minimizing the cost of capital. We expect this trend to continue into the future.
In 2013, RMD achieved a ROIC of 19%. While our forecasts project ROIC to return to a level more
consistent with its historic average, we still expect a value spread that will remain in excess of 7.5% for
all forecasted years.
Cost of Capital 2011 Weight % Cost Wgt Cost
Equity Capita l ization 6,730 100.0% 7.7% 7.7%
Tota l Debt 1 0.0% 5.0% 0.0%
Preferred Stock 0 0.0% 0.0% 0.0%
Value of Al l Securi ties 6,731 100.0%
Effective Tax Rate 20.2% Long-Term Growth Rate:
Risk-Free Rate 2.678% 3.5%
5-Yr Beta 0.743 Alternative Beta:
Market Risk Premium 6.0% 0.83
CAPM Cost of Equity 7.658%
7.658%Weighted Average Cost of Capital:
NYSE: RMD
Recommendation Summary
ResMed is a leading developer, manufacturer and distributor of medical equipment for treating
sleep-disordered breathing (SDB) and other respiratory disorders. RMD operates in an industry
that is expected to achieve robust growth in the coming years and is well positioned as an
industry leader to take advantage of this expected growth in the U.S. and abroad. ResMed has
generated strong free cash flows from last two years, with a superb ROIC of 19% and with a
corresponding WACC of 7.7% for 2013. Using a conservative forecasting approach, ResMed is
currently under-valued in the market, based on the present value of FCF.
With a 2014 per share intrinsic value of $56.28 and the current undervalued market price of
$949.25, and RMD’s strong value spread between the ROIC and WACC, RMD is an attractive buy
and hold stock for the Student Investment Fund.
RMD ResMed Inc. Sector Healthcare Report Date 5/10/2014 2008
