Listening out for growth: Cochlear Limited

Today’s CEO interview is with Dig Howitt from Cochlear Limited. Cochlear has been an incredible performer over the past few years, and as I point out to Dig, up to 2014 the share price barely moved and had been $60 or so for about 7 years and since then it’s gone to over $200 and produced compound annual growth rate total shareholder return of more than 40%. It's now selling on a PE of 45 to 50 times current year’s earnings. You’d normally look at that and go well, that’s it, there’s no more growth left there, it’s all in the price except for a couple of things.

Firstly, all of their capex, their research and development, their expenditure really is coming out of the profit before they report the profit after tax. In other words, it’s not really a true reflection of what they’re making because like Amazon they reinvest so much of their money, the profit back in the business, before you get to see the profit. The real PE is probably lower than that, who knows what it is exactly.

The other thing is there’s huge growth left particularly in India and China both for children and adults, and there’s also huge growth left in the adult segment in the developed world in Europe, America and in Australia to that extent. Dig Howitt says the penetration of Cochlear implants in the adult segment of the market, that is to say people over 60 who are experiencing age related hearing loss, is 3%. Now it will never be 100%, possibly even not 50% but there’s a huge amount of growth left in the adult segment as well as children in India and China so this is not a company that’s ex-growth and the PE ratio, their profit results, are a little bit misleading because of how much they reinvest in the business above the line. 

It's well worth listening to Dig Howitt. He has been the CEO since January but he’s been with the company for 18 years and on the executive committee for 15 years so he’s been deeply involved and it’s been a smooth transition you’d have to say. 

Here is Dig Howitt, the CEO of Cochlear Limited.

Dig, what interests me is before we get onto the more recent results, in the five or seven years leading up to 2014 Cochlear basically was flat at around about $60 each but since then you’ve delivered 40% plus total shareholder compound growth and the share price is now over $200.  Can you tell us what happened four years ago, what brought about that dramatic improvement in the total shareholder return?

Yeah, I think it’s worthwhile to go back and have a quick look at the history of Cochlear to explain what’s happened over the last few years.  If you go right back when Cochlear started the most obvious implication of the technology was in children born with severe to profound hearing loss and if you looked then at Cochlear’s growth through to about 2010 or 11 a lot of our growth was driven by children in the developed world with introduction of new born hearing screening becoming the standard of care for children born with severe to profound hearing loss to get a cochlear implant, first one cochlear implant and then two cochlear implants, bi-lateral implantation.  Right through to about 2010 or ’11 we grew on the back of increasing penetration in children and then bi-lateral implantation in children.  At about 2010 that market started to saturate so in most of the developed world there was very good screening of children, they’re getting implants quickly.  We realised we had to open up emerging markets and the adults and seniors which actually are much bigger markets but then in 2011 we had a recall which is probably one thing you don’t want to have happen as an implantable medical device company. 

At the same time we knew we had to switch our market focus, we had a recall which meant we had to sort that out, we had to focus on looking after our existing customers and making sure that we solved the problem that caused the recall which we did.

How many products had to be recalled, was it a large proportion?

It was a single implant and of that implant we had done about 30,000 of those implants at the point of the recall.  What was happening was a small proportion of those implants were failing.  We only recalled non-implanted product and I forget the exact number that we had to recall, so you don’t recall an implanted product unless it’s a safety issue and this wasn’t a safety issue.  Coming out of the recall in 2014 we then had the ability to then start focussing on emerging markets and on adults and over the last few years we’ve invested very heavily particularly in adults, so age related hearing loss and treating people, and that’s really what’s driven our growth over the last four or five years.  The other factor that’s important to overlay on that is at about the same time as we had the recall the Australian Dollar went to about one for one for the USD and then from 2013 it’s fallen back to about 74 or 73 where it is.  We got hit with a significant event in the company’s history, a foreign exchange change which limited the amount of cash we had and a need to invest in opening a new market, so since ’14 we’re going to invest in opening up more with adults and seniors particularly.  That’s really what’s driven growth over the last few years.

How much of your growth since 2014 is due to the currency declining?

Actually, if you look back at our 14 and 15 you see pretty big jumps in our reported net profit across 14 but since then it’s been driven by the underlying growth in the business.  If you look at the implant numbers going back through then we’ve grown all the way through, there’s no doubt as the currency fell we got a boost to our ability to invest which we used.

Can you give us a big picture look at how the company has changed in terms of its revenue source, children versus adults and what’s been the extent of your growth in the adult market?

Yeah, it varies very much by country and so in Australia and the US where we are most advanced in getting implants to adults and seniors our sales are about 25% to children and 75% to adults and seniors.  In most of Western Europe we’re less advanced, we’re about 50/50 adults to seniors and if you look at the emerging world, look at India for example, we’re about 95% children.

What do you think your penetration of the adult market is?

In the developed world we think it’s about 3% so still out of 33 people who would benefit from a cochlear implant one of them is getting one and most of the rest are getting high powered hearing aids.  There’s increasing evidence that shows that past a certain level of hearing loss people get very little functional benefit from a high-powered hearing aid and would do significantly better with a cochlear implant.

How much more does it cost and how much more trouble is it?

It depends on who pays.  Certainly, the overall cost of the procedure for a cochlear implant might be $25,000, and then some more on top of that for surgery whereas high powered hearing aids can be between $5,000 and $10,000.  The way to look at healthcare expenditure, which is the way it’s always looked it is what is the overall economic benefit, what’s the societal benefit, are the outcomes good and then does this treatment deliver an economic benefit.  Clearly treating hearing loss or resolving loss does deliver an economic benefit and it’s things like particularly as people age they’re much less likely to be depressed, much more likely to be able to stay independent, i.e. not need to go into aged care or a nursing home.  There’s a very link between dementia and hearing loss, now that’s a correlation at this stage not a causal link but we have over the last year agreed to give John Hopkins School of Public Health $10 million USD to research the links between hearing and healthy aging and we have also sponsored a chair in hearing and healthy aging at Macquarie University.

Presumably with the aim of getting more public funding for cochlear implants.  Who does pay now, that $25,000 plus, is it paid by the government?

Governments or private insurance depending on the country.  In Australia cochlear implants are covered by state government grants and also through private insurance.  That’s done because of the significant societal and economic benefits of people having good hearing and being able to fully function in society. 

That 3% penetration of the adult market, obviously it’s very low and plenty of potential for upside, how fast is it growing and what upside potential do you think there is in various developed countries, US and Europe in particular?

When we look at our business over 60s is the fastest growing part of the business by quite a bit.  We’re seeing double digit growth in most of the developed countries and in some where it’s up over 20% for the over 60s.  The growth is happening obviously off a very small base.  We don’t yet know what level of penetration we could reach. Our research indicates that about 75% of people with a severe to profound hearing loss do go and get a hearing aid so they know they’ve got hearing loss and they go and do something about it.  It’s unlikely all of those will then take the next step to get surgery but we think the potential is way above where we are at 3%.

How many competitors do you have and do you compete with them on price, value or brand or what?

We are very clearly the world leader, we have well over half of the world market for cochlear implants.  There are four other companies that share the rest, two of those have been around for quite a while and have reasonable shares, maybe high teens or 20%.  To hold more than half the market you need to compete on every dimension so we obviously want to compete on value, on the benefits of our technology, on our brand and our service levels but there are some markets, particularly in emerging markets, where the basis of competition is purely on price and we are able to compete very effectively there as well.  We put more into R&D than many of the other companies, possibly more than all of them put together and provided we spend that money effectively that should be able to give us a sustainable competitive advantage from the technology and therefore outcome perspective.

I’m sure you would have thought of this and I just wonder what the answer was, using your brand to launch a hearing aid so that it didn’t have to be implanted, so you had a cheaper product?

We’ve certainly looked closely at the hearing aid business and two of our competitors, two of the cochlear implant companies, are now owned by hearing aid companies so I think they’ve looked at the hearing loss market and had seen the benefits of cochlear implants and seen the fast growth in cochlear implants over hearing aids, so they’ve invested in cochlear implants.  For us to go the other way is much harder because we’d be investing in a lower growth lower margin business.  We couldn’t hold 60% of that market either so to invest in hearing aids we could only ever be a much smaller player.  When we look at it we say actually we think we can do very well in cochlear implants as we are, we have a strategic alliance with GN ReSound which is one of the major hearing aid companies and we leverage their technology which is a benefit to them and a benefit to us so it gives us some of the access to that hearing aid technology which is helpful and we jointly market hearing loss and our products in some countries as well.  We think we can get access to hearing aids without having to invest at this stage.

Fair enough.  Let’s talk about the emerging world now.  Is it the case that you basically have got growth in both children and adults and that’s what’s going on there or what?

In the emerging world it’s mostly about children and so we think the penetration of children in the emerging world is about 10%, some countries, China are much higher than that, probably between 25% to 30%, some down at 1%.  We still see a significant opportunity in children in the emerging world and it’s really a stage of development, so when governments in these countries look at healthcare funding their priority is on children over adults and the expectations of people is that they want their children to have the best healthcare as well.  We do sell some implants to adults in emerging markets but it’s 90% plus children and will stay that way for a while but over time if we predict forward 20 years we will see far more adults, we think, in emerging markets getting implants as healthcare systems develop and as economic growth continues and wealth grows in many of these countries.

I think the way the Chinese market works is a bit different, there’s a tender system there.  Can you explain how that operates and what your position in the market is?

Yeah, so in China there are two quite distinct segments, there’s the national government tender.  The Chinese national government is actually the biggest buyer of cochlear implants in the world and they’ve run a tender for about the last seven years now where they buy each year between 3,000 to 5,000 implants at a very low price, it’s purely a price-based competition.  Over time we’ve won about half of that over the history of that tender.  The much bigger part of the market now by value and about the same by volume is the private payer where people pay individually and that might be supplemented by some local level of reimbursement either at a city level or a provincial level.  That’s actually now the much bigger part of the market, we compete well there and we have a strong share in that part as well.  That is the faster growing, the tender volume has been flat or actually even slightly declined over the last few years whereas the private pay parties are showing strong double digit growth.

You didn’t get any units in the August tender, the Chinese government tender, did that worry you?

It’s disappointing, we were certainly bidding to win but our competitors bid more aggressively on price and so they won.  We’ve still got a good record over a long time there and we intend to continue to compete into the future, and we evaluate each tender as it comes up so disappointing to miss out but that’s how tenders work, you can’t win all of them.

I think you’re spending a lot of money on capex in China, can you explain what you’re spending and what you’re spending it on?

Yeah, we’re actually building a factory in Chengdu in Sichuan Province in Western China.  There’s a few reasons for that one is just as we look at our growth and look at our existing capacity we think somewhere around 2024 or 2025 we’ll run out of capacity in our Australian plants and all of our cochlear implants at the moment are made in Australia.  At some point we’ll run out of capacity and need a new factory in six, seven or eight years’ time.  We’ve looked around the world, we said where do we see the future growth, where do we see opportunity and China is on top of the list there as an attractive place to build a factory.  When we look forward over the next 30 years it has enormous growth potential and value and 30 years, we think, is a reasonable timeframe.  One of our factories in Sydney has now been running for over 30 years so we’re spending about $80 million over the next few years to build this factory in Chengdu with a very long run view of the potential in the China market.  This factory will also export as well to other countries in the world so it won’t be producing solely for China.

You mentioned that you’re spending a lot of money on R&D, as much or possibly more than the rest of your competitors put together, I think it’s 12.5% of revenue or something.  Has the technology changed much in those 30 years, is there much difference between the factory you’re building in China and the factory that’s now 30 years old in Sydney?

Actually, there won’t be much because we’ve been refitting the one in Sydney.  The base technology is very similar in terms of how it works, there’s an implant with some electronics, there’s an electrode which goes into he cochlear.  What’s changed over time for the implant is just the quality and functionality of the electronics and the electrodes have gotten thinner and more flexible which enables us to get closer to the auditory nerve.  The biggest changes have been in the external part of the system, so people wear a sound processor outside which has a microphone and a battery and all of the processing power, and that transmits a signal to the implant.  That’s changed hugely.  In line if you look at it its moved very much with mobile phones, if you go back to when we started in 1982 I think the first mobile phone was 1983 and it was about the size of a brick and had half an hour of talk time and not much else, no text message.  You look at what a mobile phone can do now, the evolution of our sound processors have been very similar, they got a lot smaller, they got a lot more powerful.  Our latest sound processor you can stream from iPhone directly into the sound processor and therefore to the implant.

It’s that connectivity and the huge improvement in signal processing which enables suppression of background noise and filtering of sound as best we can, we enable people to focus on the person that they’re listening to not 15 other people who are talking in a room at the same time.

Interesting.

We think thee is still further we can do, we’ve certainly seen significant improvements and you can see that in people’s outcomes over the last 35 years in hearing ability, we think there’s more that we can do and that’s one of the reasons why the seniors’ market is much more opportunity now.  Most seniors have age related hearing loss so they’re not like a child who is born with no hearing, or these people don’t have zero hearing, they can hear but they can’t hear enough to get to follow a conversation so they might be getting three words out of ten with the best hearing aids they can get.  Going back 20 years you wouldn’t give someone an implant who was getting three words out of ten right because the potential for them to benefit was low, now it’s very obvious that most people who get three words out of ten right with a high powered hearing aid will get seven or eight words out of ten or nine words out of ten right with a cochlear implant.  They get a significant boost in hearing and that’s why this segment of seniors, who still have some hearing but not very functional hearing, is one of our biggest opportunities over the next 10 years.

Just briefly we talked about China, is the Indian market very different to China and is there much opportunity there as well?  You mentioned it’s still 95% children and 5% adults, so is the growth potential for both children and adults in India fairly big?

It is huge.  There are almost three times as many children born with a significant hearing loss in India as there are in China so the market there is actually bigger potential again and that’s largely from a higher birth rate and higher instances of hearing loss.  India economically is less developed than China but with current growth rates is catching up and the market works in a similar way.  Over the last three or four years there’s been a significant increase in government tenders in India and that’s typically at the state level rather than the national level and there is a private pay market that is there and growing as well.  It looks at a high level similar to China and over the next 10 years I think it will continue to develop very quickly and be a very large market.  We have a very big team in India and are very focussed on succeeding in India in the long term.

Can they afford them or do you have to reduce the price?

Again, we have a range of prices.  In these tenders and the lower priced segments of the market what we do is we offer our older technology, so it’s still very good technology, particularly for children with a profound hearing loss it gives them a very good outcome and then we keep our later technology which we price in India and China at similar levels that we price through the rest of the world.  We use different generations of technology to make product more affordable for our customers.

You’ve been with Cochlear for 18 years but you were appointed CEO in the beginning of this year, have you made many changes to the way the company runs, to the team, to the operation of the business or is it steady as she goes?

What we’ve been doing is refining what we’ve been doing.  We’ve set our strategy over the last several years, I’ve been on the executive team for 15 years so I’ve been part of setting that strategy and if you look at our results our strategy has been working in terms of expanding into the adults and seniors’ segment in the emerging world.  The things that we’re doing a bit more of now is one is we’ve said that we’re going to invest more in growing the business.  In the past we’ve been not only growing our revenue but then trying to expand our profit margin, now we’ve said we won’t try to expand our profit margin we will still work very hard for efficiencies and savings across the business but we will reinvest all of those into future growth so we’ll be much more explicit on investing in future growth.  We have taken our strategy and worked through I think another level of detail on how do we implement the strategy, how do we measure how well we’re going. 

Because we are asking shareholders to bear with us as we invest more in future growth we need to be able to measure the effectiveness of those investments, be very clear on what those investments are and be able to measure them very well so that we can continue to correct the course ourselves and also show our shareholders the investments we are making on their behalf are effective.

What does that mean for dividend and the payout ratio which I think, what is it, about 60% or 70%.

70%, yeah our intention is to hold the dividend payout ratio at 70% so most of our investment goes through the P&L rather than through the balance sheet.  We have very high free cash flow generation so our operating cash flow is generally about the same as our net profit or slightly higher.

It’s above the line?

Yes, it’s all above the line.  The thing we’ve been explaining to our investors   is you can’t really look at our balance sheet and say where are you investing, yes we have some investment through the balance sheet in terms of capex but the majority of our investment goes through the P&L.

That’s what Amazon does.

Yes, I think it’s a characteristic of companies where knowledge is critical and the value is intangible, so it’s in our IP, it’s in our knowledge base, our knowhow, our brand.  You invest in those things through the P&L, not through the balance sheet.  I think investors are thinking how do we work this out, how do we look at companies like us that have a very high tangible value and do normal metrics and ratios and valuations applying or not.

Does that mean, do you think, that investors shouldn’t take too much notice or at least should look differently at the PE ratio?

I think if you look at where the share price is they already are.  Our PE is somewhere between 45 and 50 depending on where the share price is and there are a few companies up there on the ASX that have that sort of PE so I think investors are already doing it that way.  Our goal is to run the business really well, to be very clear on what our strategy is which is to reinvest in future growth in those segments and it’s then really up to the market and the investors to work out how they value us.

I put this question to Paul Perrault of CSL, who is one of those companies you mentioned, and asked him and as you now, do you feel with a 45 times PE do you feel under the lash, that you’ve really got to perform or you’ll get smashed?

No more so than I think with a lower PE.  We have to perform, that’s our job, that’s the expectation on the company, it’s the expectation on me and the executive team, is that we will execute our strategy very well and that will deliver continuing growth.  How people value us is really up to them but I don’t feel more pressure because the share price is higher.  We just execute very well all of the time irrespective of where our share price sits and it will move around, our share price, and there are broader factors at work in the valuation than just Cochlear as a standalone and depends on other options in the market and how much money is available and so on.

I suppose the point is that your strategy over the past few years has ensured that you’re not in the saturated business, you’ve still got plenty of growth ahead either in India and China and in particular in adults.

Yeah, we’re incredibly fortunate to have the growth opportunity we do, to have the competitive advantage we do, and you overlay all of that with helping people hear which is emotionally very satisfying for all of our employees and a great motivator for people, and life changing for the people that we help and their families.  We continually hear those stories back from our customers of how their life has changed or their grandfather’s life has changed or their child’s life has changed.  That’s what really gets us into work every day.

Great to talk to you, Dig, I appreciate it, thank you.

Thank you very much, Alan, good to talk.

That was Dig Howitt, the CEO of Cochlear.