Markets tend to be efficient over the long term however in the short term, this is not necessarily the case. Investors often overreact to bad news and treat temporary setbacks as permanent.
A company recently in the cross-hairs of investor fear is ResMed Inc. (CHESS) (ASX: RMD). ResMed is a leading global supplier of sleep apnea products, including flow generators and associated masks. The company has been developing devices for sleep-disordered breathing, chronic obstructive pulmonary disease and other chronic diseases for more than 25 years.
The company recently announced that clinical trials of a special form of sleep therapy designed for patients who suffer from both heart failure and central sleep apnea failed to protect those patients from death or complications associated with heart failure. The share price reaction was savage, with a fall of 15%, wiping $2.1 billion off ResMed's market capitalisation.
The disappointing results from the clinical trials relate to a segment of the flow generator products, that accounts for less than 7% of group revenues. Further, the specific issues found in the clinical trials relate to only 25% of these flow generators. In other words, the impact to ResMed's revenues is less than 2% and less than 1% to net profit. A 15% drop in the share price would therefore suggest investors may not have been acting rationally in response to this announcement.
A good comparison is Cochlear Limited (ASX: COH). In 2011 the company announced a product recall of one of its key cochlear implants due to implant failure. This was a major setback for the company as the product was absolutely core to its business. The resulting 37% share price fall wiped around $1.6 billion off Cochlear's market cap.
However, unlike ResMed, the announcement had serious implications for Cochlear's profits. In FY2011, the year prior to the product recall, Cochlear made a net profit of $180 million. In FY2012, the year of the product recall, the company made just $57 million in net profit. In fact Cochlear's earnings are still only approximately half those posted prior to the recall and yet the share price recently hit an all time high. Given the announcement by ResMed will not materially impact earnings, I would expect its share price to also recover.
Foolish Takeaway
Warren Buffett once said that it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price. ResMed operates in a very attractive industry. Sleep apnea is a growing market with an estimated 26% of people aged between 30 and 70 affected by the disorder and ResMed contends that only a small proportion of sufferers are currently diagnosed.
The business has a wonderful track record of growing earnings, generates a high level of free cashflow, is debt-free and applies surplus cash to buying back its own shares. Although disappointing, it would appear as though the announcement will have very little impact on ResMed's near term earnings yet the share price reaction would imply otherwise. Sometimes the market provides investors with an opportunity to buy a wonderful business at a fair price and we may be seeing that now.
