thinking about risk-adjusted returns

In an earlier post on RMD I alluded to providing my sixpence worth of opinion as to what I expect from RMD in terms of growth in intrinsic value - and hence share price -over my investment time horizon of 3 to 5 years.


LOW-ROAD SCENARIO

In dimensioning this, I start by looking at the "Low-Road" Scenario, one in which:

1. The company's top line growth slows to a far lower rate (10% pa going forward) than that achieved over the company's history (13% pa CAGR over the past 5 years, and 18% pa over the past 10 years), and

2. Gross Profit margins revert to their historical average of around 60%, from their current near all-time records of circa 63.5%.


The resulting growth in NPAT is around 11% pa (recall that this compares to the company’s long-term NPAT CAGR of around 20% pa).

Consistent with the "Low-Road" scenario, it is assumed that the company's valuation multiples remain unchanged at their current levels which, incidentally, are at near all-time lows.

For context, the stock's current P/E multiple is 19.0x and the EV/EBITDA multiple is 12.5x. This compares to average P/E and EV/EBITDA multiples over the past 10 years of 28x and 15x, respectively.

In this case, my modelling throws up average share price appreciation of some 9% pa, plus a dividend yield of 2% pa, for a Total Shareholder Return (TSR) of 11% pa.


[For further context, recall that RMD's share price has risen by around 17% pa, on average over the past decade.]



MIDDLE ROAD SCENARIO

Here I've assumed 12% pa growth in Revenue and for the Gross Profit Margin to remain at the current levels of 63.5%.

This GP Margin assumption is an important one, because I think it is where the company has scope to continue to surprise on the upside, going forward. This is because of the ongoing evolution of the company's masks and their applications, moving up the quality spectrum into areas of more complex sleep disorders, such as Central Sleep Apnoea, and away from the commoditised end of the product suite.

Under these settings NPAT growth is expected to be around 16% pa.

I have also in this case applied the same discounted Valuation Multiples as those assumed under a Low-Road Scenario, i.e., no upwards re-rating of the stock to historical levels.

In this case the resulting TSR would be 13% pa capital growth, plus 3% pa in DY, for a TSR of 16% pa.



HIGH ROAD SCENARIO

As per Middle Road, but with historical multiples restored, namely P/E of 22x and EV/EBITDA of 15x.

The resulting TSR would be 20%, comprised 17% pa capital appreciation plus 3% DY.



Now I know that this sort of exercise is an imprecise science given the long-duration nature of such predictions, and normally the forecast risks are too high to justify doing the work.

But in RMD’s case, I would argue that it does serves as a somewhat useful guide.

So the way I look at RMD as an investment at the stock’s current levels is that it, over the next three years, offers a total annual return somewhere in the mid-teens.

Now I appreciate that sort of return might be too low for many retail investors who are looking for every investment to be a multi-baggers each year, but I always think it is important to consider Returns on a Risk-Adjusted basis.

And in RMD’s case, the delivery risks are considered to be very low given:

1. the increasingly strong underlying demand growth for their products

2. RMD’s leading industry position in terms of R&D benchmark and lowest-cost manufacturing,

3. The pristine quality of RMD’s balance sheet, and

4. The company’s extensive financial track record throughout all manner of business and economic cycles


I’d therefore classify RMD as a low-risk, medium-return investment, for those who go for that sort.

It's what it sometimes called a "slow burner".



Cam


PS. Note that none of the admittedly rudimentary analysis above incorporates any upside – either in earnings or valuation rating – from success in the significant Serve-HF heart failure trials currently underway.

PPS. Nor does it incorporate any benefits – both operational and translational – that a lower A$:US$ exchange rates over coming years would deliver.

PPPS. I’m very proud to have completed the entire post having totally resisted the temptation to make use of the painfully obvious “sleep-easy-at-night investment” pun.