January 13, 2007
THE sleep disorder market is the biggest untapped medical market in the world.
It starts with snoring and sleep apnoea but it extends to heart attacks, diabetes, impotence, occupational health, obstetrics and many other areas.
Australian-based ResMed is the global leader in this market and is almost certainly one of Australia's premier growth stocks among the top 50 companies.
Only ABC Learning would rival it among the non-resource stocks.
ResMed is forecasting 20 per cent growth into the foreseeable future but it has been growing at an average annual rate of 32 per cent for 10 years.
The company's internal targets are closer to past performance.
Any company with turnover of around $1 billion growing at more than 20 per cent a year has a significant management challenge.
The market is backing ResMed management to deliver.
Excluding stock-based compensation, restructuring and acquisition expenses, the company earned $US1.42 a share in 2005-06 or $1.82 based on a US78c exchange rate.
Three years of 25 per cent growth would take earnings per share to about $3.50 and a 30 per cent growth rate would lift earnings to about $4.
That's why the stock is priced around $63 or a price-earnings ratio of 35.
If you use official US accounting standards, earnings per share fall to $US1.16 or $1.49, which takes the PE ratio above 40.
If anything goes wrong with a stock like ResMed over the next three years, the price will be severely punished.
ResMed and the US company Respironics each have about 40 per cent of the global sleep market. But ResMed has been growing its sleep business at twice the rate of the US company.
ResMed founding chairman and CEO Peter Farrell explains why the potential market for sleep disorder treatment is so huge.
He believes that about one in three or four people in the Western world have sleep disorders, of which the main disorder is obstructive sleep apnoea (OSA), which is the No1 cause of hypertension.
Hypertension is the main cause of two of the top three Western world killer illnesses - heart failure and stroke.
But it has also been discovered that sleep disorder problems exist in a large number of type 2 diabetes sufferers. Sleep disorders also play a role in obstetric and gynaecology problems.
Farrell says that although ResMed has achieved enormous growth rates, the potential is huge because the medical profession is only just waking up to the role of sleep disorders in so many of their patients' illnesses.
The sleep market starts with the "simple" problem of snoring.
Farrell says: "The problem is that if you are 'just a snorer', it is your bed partner that suffers and it probably breaks up more marriages than infidelity and financial issues.
"And we can fix it. Unfortunately, there is an appalling lack of education about sleep disordered breathing and obstructive sleep apnoea in medical schools.
"As a consequence, physicians often incorrectly refer patients with sleep disorders to urologists (study of urine), gastroenterologists (stomach), cardiologists (heart), neurologists (headaches), psychiatrists (personal), and so on, without any appreciation of the underlying sleep disorder pathology."
In addition, in the US the market for sleep disorder treatments is greatly slowed because a simple treatment process is made much more complex by elaborate testing bureaucracies.
Farrell says that apart from the lack of education in medical schools, one of the reasons the profession has been so slow to recognise the role of sleep disorders in so many killer illnesses is that "medicine stops when the lights go out".
"Think of a hospital," he says. "You've got the least qualified staff volunteering to work all night. And at night, there is the lowest number of staff to patients. The guy (just) sits there with a book."
A buzzer goes off. He goes down and fixes the drip. He goes back to the book. There is no observation.
"It is a bit like Sherlock Holmes to Doctor Watson," Farrell says. "Doctor Watson, you see but you don't observe. There is no observation at night.
"It is all 'I'll see you in the morning'."
ResMed is working to change medical attitudes, but it is a slow process.
It has about 4 million patients being treated around the world and it sells about 80,000 breathing devices and 360,000 masks each month.
The devices vary from a standard $1000 unit to sophisticated ventilators that closely measure breathing for patients with severe heart problems. Margins on the standard lower-priced units are low, but are much higher once more sophisticated equipment is used.
Most patients need new masks regularly, so the company has a substantial annuity income and the mask business is high-margin.
And because the cause of people's illness is being curbed, their lives are being extended and so the ResMed annuity stream is a long-term one.
If there is a big rise in the usage of sleep disorder treatments, then not only will ResMed enjoy initial income from the sale of devices but its annuity stream will underwrite a higher level of long-term earnings.
And to further assist annuity streams, many of the new ResMed masks actually trigger a re-ordering process once they are near the end of their life.
ResMed is working in the US to simplify its apparatus and therefore widen the market.
It has been helped by the US private trucking giant Schneider, which has about 15,000 drivers.
Chief executive Chris Lofgren went on a ResMed machine and saw the benefits. Now 1000 of his truck drivers have had their sleep disorders eliminated by ResMed machines. Lofgren has told them: "If you don't use your machine, go find another job."
Penetrating the US occupational health and safety market will be a long process, but the Schneider policy was a big breakthrough and if, longer-term, Schneider health problems are substantially reduced, it will help open the US market.
What can go wrong with ResMed? Obviously, the current dramatic results linking sleep disorders to so many killer illnesses must not be contradicted by later findings and the high machine safety record must be maintained.
It is remarkable that so few companies compete in this market.
To protect its market leadership, ResMed has 1000 patents existing or in progress and has effectively established a spider web of patents so that if a patent is about to expire, the company has intellectual property process to follow through.
The company believes this protects its position, but obviously if a new sleep disorder treatment breakthrough was made by a rival it would affect its growth, although big new developments usually take time.
ResMed spends about 6 per cent of its revenue on research and has a strong pipeline of new products to improve sleep treatments and develop new markets.
The pains of growth won't be easy to manage. The company recently spent $250 million building a factory in Sydney and now thinks it probably should have spent four times that, given the growth rate.
Because of the growth rate required by the market, management succession will be important.
It is likely that in the next year or two Farrell will hand over the CEO reins to his No2, Kieran Gallahue, but he will remain as founding chairman.
Two years ago Gallahue was promoted to president of ResMed Global, assuming responsibility for global operations, new business development and product innovation, in preparation for a future CEO handover.