Comparing Cochlear, CSL and ResMed

Australia boasts an impressive record in the fields of science and medicine. Including the recent award for Elizabeth Blackburn, 10 of our 11 Nobel laureates have been scientists. The famous names include Howard Florey (penicillin), Robin Warren (ulcers) and Peter Doherty (immunology).
That Australia operates at the forefront of health sciences is also evidenced by three world-leading healthcare companies; CSL, ResMed and Cochlear. If not the number one, each is highly respected in its field and behind each of these stocks lies a tremendous success story.
Cochlear is firmly established as the market leader in its field of bionic ear implants, CSL is one of the world’s largest blood fractionation companies and an innovative vaccine researcher and manufacturer, while ResMed has been steadily taking market share away from formerly dominant competitor Respironics in the market for products to treat people suffering from sleep disordered breathing.

Putting things in perspective

After recently analysing ResMed, we thought it worthwhile comparing the company to Cochlear (a successful recommendation of many years’ standing) and CSL (which we haven’t been following recently due to the business’s increasing complexity).
Before jumping in to the numbers, it’s worth considering the pros and cons of comparative analysis. On the plus side, it can be a useful tool to improve your understanding and put things in perspective. For example, our analysis showed ResMed to be a high quality company; but is it simply better than average, or is it right up there with the likes of its higher profile peers, CSL and Cochlear?
The limitations and pitfalls of comparative analysis mainly relate to the old adage of comparing apples with oranges. Lining Woolworths up against Coles is very different to comparing ResMed and CSL. Australia’s retailers compete head on, operating directly comparable businesses in the same market; while the only thing ResMed has in common with CSL is that they both operate in the huge and broadly defined ‘healthcare industry’.

And the winner is…

It’s easy to define general notions of ‘business quality’. Being profitable and growing those profits over time is a strong indicator of quality and is straightforward to measure. Even more importantly, though, those profits should represent an attractive return on the investment of those who have put their capital at risk by supporting the business (shareholders and lenders). We’ll be using a measure of this aspect shortly. But before hitting the numbers, it’s worth touching on the qualitative side of things.
While we won’t be incorporating the ‘soft side’ of analysis in this exercise, a full comparative study would require judgments to be made on factors such as brand power, management ability and industry dynamics. For example, WA News may operate a very profitable and focused newspaper in Perth but how certain can one be about the long term profitability of newspapers? Billabong is undoubtedly a great brand, but can the company continue to produce popular products in the future (which was the topic of a recent podcast discussion – you’ll find it just after the 7 minute mark)?
Table 1 lists a number of quantitative indicators of quality which can be calculated by combining some analytical elbow grease with a stack of annual reports; return on capital employed (ROCE), operating profit margin, earnings per share (EPS) growth and free cash flow to net profit after tax (FCF/NPAT).

The most important of these, in our view, is ROCE (pronounced ‘roe – kee’ by some fancy management consultants). It’s a measure of how much capital (equity plus net debt) a business uses (or ‘employs’) to produce its profits. Better businesses should display a higher ROCE, perhaps due to a strong brand, customer service, economies of scale or some other competitive advantage. Unlike profit margin, ROCE is also a ratio that can be used to compare companies in different industries.
The table shows that in 2009 Cochlear had the highest ROCE of the three at 38.8%. CSL wasn’t far behind at 35.8% and ResMed’s was further back at 22.9% (though that probably still ranks in the top 10% of ASX companies).
Another indicator of quality is FCF/NPAT. It measures how much of a company’s reported net profit after tax (NPAT) converts into free cash flow (FCF). Some companies report terrific profits but produce little free cash flow because the business requires large amounts of capital to be reinvested to keep the business growing (the wine and airline industries are prime examples). On this measure, Cochlear again leads the way with 92.1% cash flow conversion in 2009.
Some companies grow profits but issue lots of new shares, meaning that the important measure of ‘earnings per share’ grows much more slowly than reported profits. For investors, earnings per share are much more important than headline profits. CSL is the winner in this category, recording 33.5% growth in 2009, followed by ResMed and Cochlear.
Profit margin, (a measure of profit per dollar of sales), is most effective when comparing similar businesses, or the same business over time. In this case, it shows some correlation with ROCE, which may be worth noting. But we wouldn’t rely heavily on this measure in this case, given important differences between the companies.

Looking back

Overall, Cochlear was probably the winner for 2009 based on its ROCE and cash flow conversion. But that doesn’t necessarily make it the best company. Last year might have been a particularly good one for Cochlear and a bad one for ResMed. As long term investors, we want to lift our financial gaze to a longer horizon. While we’re most interested in the next five to 10 years, perhaps the past five can provide some useful context.
Table 2 provides a number of five year averages, including the compound annual growth rate (CAGR) in earnings per share (EPS) and dividends per share (DPS).

Over the past five years, CSL led the way in earnings per share growth with an impressive CAGR of 32.6%. It also has the highest average FCF/NPAT at almost 100% and the highest dividend growth rate.
Cochlear maintained the highest average ROCE, at 37.9%. Though we note that this is well down on the average of the five years to 2004 where Cochlear’s average ROCE was an incredible 100.6% (CSL and ResMed’s were 12.7% and 23.6%, respectively). CSL is the only company to increase its average ROCE over the past 10 years.
To rank the companies, we’ve created a ‘Quality index’ by adding annual ROCE to EPS growth and multiplying this by the five year average FCF/NPAT conversion. While necessarily subjective, the idea is that the best company is the one that can grow profits the fastest, while employing as little capital as possible, and then convert that profit to cash flow. On this measure CSL come out ahead of Cochlear, with ResMed collecting the bronze medal in a tough field.

    
It’s worth pointing out that ResMed is penalised, as it should be, by its poor cash flow conversion. However, as highlighted in our analysis last issue, ResMed’s cash flow has improved significantly over the past two years.

Valuation

It’s a relatively easy task to identify a company that has been successful in the past. Much harder – and more important – is spotting the ones that will be successful investments in the future. The key here is valuation.
The business world is uncertain and valuation is the crucial process of using probabilities to take into account the various outcomes which may eventuate. A company may be extremely high quality, but if it also has a high price tag, then investors may suffer if profits fall short of lofty expectations.

A selection of common valuation metrics for our comparison companies is provided in Table 3. On the surface, CSL looks the best value with a PER of 18 times its 2009 earnings per share of $1.70. Cochlear has the highest PER but also the best dividend yield of 2.7%.
Though operating in different fields, we hope the comparison has provided new insights into these high class Australian healthcare companies. Many of our members have already profited handsomely from Cochlear’s growth and we look forward to recommending CSL and ResMed when the price is right.