Does ResMed Pass Buffett's Test?

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We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's look at ResMed (NYS: RMD) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital


(Get further detail on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for ResMed and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

ResMed18.1%18.2%13.7%13.4%
Accuray (NAS: ARAY) (15.4%)*17.5%(4.6%)*(25.8%)
CONMED (NAS: CNMD) 5.8%**4.7%6.1%5%**
Varian Medical Systems (NYS: VAR) 38.7%42.3%36.1%47.3%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Accuray did not report an effective tax rate, we used its 33.4% rate from five years ago.
**Because CONMED did not report an effective tax rate, we used its 33.5% rate from one year ago.

Varian Medical Systems has by far the highest returns on capital of these companies, but those returns have declined from five years ago, though they're still substantial. ResMed's returns are also much higher than Accuray's or CONMED's, and its returns have grown by almost 5 percentage points from five years ago. CONMED's returns are currently slightly higher than they were five years ago. Accuray's returns are in the low negative numbers, which is caused by its negative EBIT. While it has improved its returns slightly from five years ago, it still has a long way to go to compete with the other companies in its ROIC.

ResMed is a dominant player in a growing market for CPAP machines, which treat sleep apnea. Sleep apnea is a medical condition in which a brief collapse in the airway causes individuals to temporarily stop breathing while sleeping, which wakes them up. One of the leading causes of this problem is obesity, which is a growing problem in the U.S. and may explain some of the demand for products treating sleep apnea.

Accuray has a product called CyberKnife that's used in innovative radiological treatments and can sometimes be used in place of invasive surgeries. Accuray's competition in this area includes Varian Medical Systems and Siemens (NYS: SI) , which have products that also assist with radiation therapy. However, one move Accuray made in attempt to maintain dominance includes buying out competitor TomoTherapy.

CONMED sells surgical devices and equipment that medical practitioners use to monitor patients and carry out minimally invasive surgeries. The company also acts as the exclusive global marketing representative for the Musculoskeletal Transplant Foundation's (MTF) sports-medicine allograft tissues. CONMED will also serve as MTF's distributor for its platelet-rich plasma, which uses patients' own blood components to heal them. This deal gives CONMED $63 million in upfront payments and brings the potential for the company to make an additional $84 million over the next four years if MTF can meet supply targets.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

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At the time this article was published Jim Royal, Ph.D., owns no shares of any company mentioned here.Motley Fool newsletter serviceshave recommended buying shares of Intuitive Surgical. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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