Value.able: Listen up

Any setback in the share price of hearing implant maker Cochlear should be regarded as a buying opportunity.

PORTFOLIO POINT: Investors should regard any blip in the share price of hearing implant maker Cochlear as a buying opportunity.

One of the easiest and surest ways I know of making a positive return in the stockmarket is to keep your money in the bank until Cochlear announces a short-term problem, or one of its competitors announces a new model.

Cochlear sells 70% of the world’s hearing implants, but it is in a competitive market, so each time one of the major players releases a new product it is the latest and greatest (except those that require a recall), leaving investors wondering whether it will steal market share.

As Australian investors, we are concerned about the impact of such events on Cochlear’s profits and market share.

But Cochlear, with the lion's share of the market, and with the exception of recent jitters, holds a reputation for excellence and reliability. And so it was again this financial year that another short-term blip on the company's impeachable history was treated like a long-term or even permanent impairment.

It was reported by one major broking analyst that “the recall of the Nucleus 5 implant would be negative to Cochlear's reputation as the only company in its peer group without a major recall.” That analyst reduced his recommendation on the stock to a “sell”.

Because the same investing mistakes are repeated time and again, we took advantage of the temporary declines in Cochlear’s share price to accumulate a position for investors in the Montgomery (Private) Fund. From their post-recall lows, the shares have been at one point up 42%.

Cochlear's 2012 half-year result proves that it is very hard to keep this A1 company down. Revenue increased by 3%, to $387.5 million. And impressively, sales increased despite the recent recall. Of course, as expected and as a result of the recall the company lost $20.4 million. The reported loss, however, includes $138.8 million before tax charge to the cost of sales, and $100.5 million in after-tax product recall costs. This will be one-off and, apart from the product recall impacts, all seems quite normal.

Interestingly, provisions have increased sharply, by $62 million, to cover any future potential recall expenses. Should all provisions be required, an entire year's profit will been wiped out. It would have been nice if the shares had been wiped out too – giving rational long-term investors the opportunity to purchase more.

While debt increased by $20 million, net debt to equity is a paltry 2%. Operating cash flow was down, as is to be expected given a product recall, but free cash flow was in excess of the same period last year.

The failure rate on the faulty nucleus CI 500 implants appears to have peaked at 2.4% and has been declining since October. While operations to remove implants are more than a little inconvenient for patients, there are no reports of injury or pain. About 2300 units have been recalled and costs have been fully expensed in the half-year result. Record sales suggest there has been no brand damage globally and supply issues that plagued the company in the first half, while production of a replacement implant was ramped up, will not be a feature of the second half.

Cochlear retains an MQR (Montgomery Quality Rating) of A1. And indeed it is an A1 among A1's. Cochlear shares however have rarely traded anywhere near our conservative estimate of intrinsic value, let alone a discount. Indeed, the closest the shares ever traded to intrinsic value was in August 2004, when at $19.28 they were just 50¢ above their intrinsic value.

Since then they have surged above $62 and now trade at almost double my most conservative estimate of intrinsic value. Even though I expect intrinsic value to rise at approximately 20% per annum for the next few years their current premium to intrinsic value suggests returns will now be more muted. Cochlear remains an A1 business so I have no interest in selling any substantial proportion of my holding however I do not expect further substantial gains either. If you, like me, purchase shares following the recall you may like to speak to your adviser about their opinion.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.