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Morningstar | Disappointing Homecare Growth and Outlook but Review of Systemic Risk Has Us Raise FVE to NZD 16.40

The transition of coverage to a new analyst and reduction in cost of equity following a review of narrow-moat Fisher & Paykel’s systemic risk exposure has us raising our fair value estimate to NZD 16.40 from NZD 11.00, despite weaker than expected growth reported and a subdued outlook in the homecare division. Based on an AUD/NZD exchange rate of 1.05, our fair value estimate is revised to AUD 15.60 up from AUD 10.70.

Fisher & Paykel reported constant currency revenue growth of 8%, well short of their 12% long-term aspiration. The top line was pulled down by a weak performance in homecare masks, flat on the year in constant currency but down 2% in the second half on the previous corresponding period, or pcp. Homecare masks for the treatment of obstructive sleep apnea, or OSA, make up around 80% of homecare revenue and the outlook is for the decline to continue into first half of fiscal 2020 with some reprieve in second half as the newly launched Vitera mask is expected to gain regulatory approval in the key U.S. market. We expect homecare revenue, which contributes 40% of group revenue, to be down 1% in fiscal 2020 and improve to 2% per year growth thereafter.

Conversely, our outlook for the key hospital division which currently contributes 60% of revenue remains intact. We forecast continuing 20% growth rates in new applications driven by the ongoing adoption of Fisher & Paykel’s Optiflow product in a deeply underpenetrated market. We forecast a group five-year forward revenue CAGR of 9.5% versus an 11.4% five-year trailing growth. Overall net profit after tax, or NPAT, for fiscal 2019 at NZD 209.2 million was at the top of the guided range of NZD 205 million to NZD 210 million. Our NPAT forecast for fiscal 2020 of NZD 237.2 million is below the management range of NZD 240 million to NZD 250 million based on a more subdued overall revenue forecast. This equates to diluted EPS of NZD 40.9 cents per share growth of 13.0% on the pcp.

Two major positive contributors to the earnings outlook are a significant reduction in intellectual property litigation costs and a lower effective tax rate stemming from a new R&D tax credit in New Zealand. With the company and ResMed having settled major outstanding litigation out of court in February 2019, we expect the annual cost to reduce to around NZD 5 million in fiscal 2020 from NZD 23.4 million in fiscal 2019. The newly introduced R&D tax credit which amounts to 15% of eligible expenditure has the effect of reducing the effective tax rate expectations to around 25% from 28.5%. This has the effect of boosting not just near-term earnings, but our fair value estimate by NZD 0.70 as we assume it remains in place over the long run. The tax credit replaces an annual NZD 5 million grant income Fisher & Paykel was receiving and at an estimated NZD 12 million in fiscal 2020 provides a net benefit to the company.

Offsetting this positive, Fisher & Paykel’s rapid margin expansion is nearing an end. Reported fiscal 2019 gross margin of 66.9% is well above the 65% target and is guided to reduce by up to 0.5% in fiscal 2020 due to start up costs in the new Mexican factory. Despite the near-term downward guidance, we still factor in gross margin improvement up to 68% by fiscal 2024 as more consumables production is shifted from New Zealand to the lower-cost Mexican facility. Operating margin before litigation costs at 29.5% was close to the 30% management target and despite a dip down to 28.0% forecast for fiscal 2020, based on the lower gross margin and removal of grant income, we forecast the firm achieving 30% by fiscal 2024.

The dividend payout ratio of 61% is disappointing given the 65% payout in the pcp and 70% long-term guidance. It is likely a function of being near the high point of the capital expenditure cycle with fiscal 2019 capital spend of NZD 133 million, or 12.4% of sales, forecast to peak at NZD 150 million, or 13.1% of sales, in fiscal 2020 reducing to 8.0% of sales thereafter. Balance sheet gearing remains limited and we forecast the company be net cash positive at the end of fiscal 2020.

We increase our fair value estimate to NZD 16.40 from NZD 11.00 as we update our cost of equity assumption to below average from average to reflect the low systemic risk inherent in Fisher & Paykel’s business. The company’s revenue demonstrates low correlation to broader economic conditions which was demonstrated by the ability to grow through the global financial crisis. Healthcare stocks, like Fisher & Paykel, enjoy defensive revenue streams, particularly when they are exposed to multiple geographies and don’t have single product dependency, which supports our below average cost of equity assumption of 7.5%. As the company carries no debt on average this is also the weighted average cost of capital.