Investor eyes on hearing group

Recently a company I think is one of the very best companies listed in Australia suffered another share price set back. But, as a value investor, I don’t take my queues from price, so I wanted to know whether the Cochlear correction was an opportunity to share with you.

Cochlear (ASX:COH) manufactures implants for the hearing impaired. As a result of being technically superior to its competitors, Cochlear has achieved remarkable success, enjoys considerable margins, maintains a fortress-like balance sheet, and has grown its earnings per share by 21% annually from 2004 to 2011. Last week, the company reported a huge 481% half-year profit rise to $77.66 million and pointed to strong long-term growth. But the market’s response was to mark down the company’s shares by about 13%, from above $80 to around $70, and they are continuing to trade at that level.

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Cochlear’s management has plans to double the size of the company and double it again, and competitors have been unable to make a serious dent in those plans.

But when Cochlear announced a global recall of its product in September 2011, the company’s share price subsequently fell from above $70 to below $50.

The proportion of Nuclear CI500 series implants failing was small – less than one per cent – and while the quick response by the company was reputationally enhancing, the market had definitely other ideas. The share price reaction at the time presented a mouth-watering opportunity and one I was quick to take. Is the most recent share price setback offering the same opportunity?

Cochlear was able to rely on its previous model (the Nucleus CI24RE) to use with the new processors, and practitioners continued recommending Cochlear implants. I took the opportunity to acquire as many shares, at an average of $50, as my portfolio construction process would allow. It goes without saying that watching the share price rocket to $70 within 12 months was satisfying. But at that price I took my profit, disappointed the market had once again got ahead of itself. It was far less satisfying, however, to see the price subsequently rally to more than $80.

Such is the fickle nature of the market that Cochlear shares have more recently traded down to less than $69, making my sale at around $70 look almost prescient.

Management quantified the loss from the recall at $138.8 million in their 2012 full-year reports. While this estimate comprised all costs associated with the write-down of inventory, the key questions were; how much the recall impacted Cochlear’s market share and would sales of the CI24RE be sufficient to sustain earnings growth?

Last week’s 2013 half-year results provided some answers and insights.

I estimate Cochlear’s share of the implants market has fallen by around 5% during the first half of the 2013 financial year to less than 70%. That’s a big drop in a short space of time. The market share is likely to have been ceded to Advanced Bionics. Unlike Cochlear, Advanced Bionics has a tactical approach to releasing products – it tends to favour user-focussed additions over revolutionary technological advances. For instance, Advanced Bionics is actively promoting a waterproof model of its implants, whereas Cochlear only offers implants that are water-resistant. However, Cochlear’s management believes that their technical innovation holds an edge over Advanced Bionics’ tactics.

So the critical question is whether this is a temporary set-back while Cochlear recovers, or is the company’s dominant market position on shaky ground?

Cochlear’s competitive advantage, and the key to its current popularity and future growth, is the technical superiority of its products. The company has spent hundreds of millions of dollars in research and development over recent years, and expects to quadruple investment in infrastructure in the coming years. Despite this strong pipeline and clear evidence of a future superior offering, Cochlear has a policy of ‘keeping mum’ on products in development until all approvals have been received. Conversely, Advanced Bionics is actively promoting its new sound processor, despite the product still pending regulatory approval.

Management at Cochlear have acknowledged that their steady approach may result in lower sales in the short term as older models are sold for longer and promotion for new models is delayed. Despite the recent recall, Cochlear enjoys an excellent reputation, which it does not want to put at risk with an early recall, or by promoting a product that may ultimately be delayed. By way of example, even though Cochlear has received all the necessary approvals to reintroduce the CI500 series, management are content to slowly re-release the product. This approach also allows the company to integrate more advanced manufacturing techniques into its supply chain, which wouldn’t be possible if the release was rushed.

Ultimately, it is Cochlear’s focus on innovation that enabled the company to emerge relatively unscathed from the recall. Competitors who have gone through similar recalls have been forced to remove their products completely from the market, with no back-ups to rely upon.

I don’t believe the company has lost its technically superior status, and while Advanced Bionics is aggressively chasing market share Cochlear need not rush to respond. When contrasting the companies’ strategies, I have a sense that Cochlear will be the company to make the next leap forward in the industry – and this is something it will do in its own time.

The company’s share price is not yet trading at a significant discount to my estimate of intrinsic value. While leaping in immediately is not warranted, I do think investors should be watching very, very closely. If Cochlear’s management have their aspirations fulfilled, the business will indeed double in size and then double again.

Any fears of a general or macro nature such as fiscal cliffs, ‘Grexits’, or Chinese hard landings may just be the catalyst to hand Cochlear shares at a price that would make the investment both a growth and value opportunity.

Roger Montgomery is the chief investment officer at Montgomery Investment Management. If you would like the opportunity to discuss your portfolio and investment options with Roger or his team simply email office@montinvest.com.