Cochlear cops an earbashing

How are the mighty fallen. It’s been a good ride since bionic ear manufacturer Cochlear first listed on the ASX back in 1995, with the stock gaining about 19% a year on average. But it has had some extreme setbacks.

This year it suffered two one-day falls of 9% (on 5 February after its interim result suggested pressure on margins) and 18% (after the profit warning on 3 June). There have been five other occasions since 2000 when the stock has fallen by more than 10% in a day, as you can see in Table 1. And it has risen by more than 10% in a day on seven occasions.

This sort of volatility is just what you’d expect from a highly priced growth stock. Small changes in people’s assumptions about future growth have a big impact on their assessment of value.

That has delivered us plenty of opportunities over the years, including our upgrades on 17 Dec 03 (Long Term Buy – $20.70), 18 Mar 04 (Buy – $19.04) and, most recently, on 3 June 13 (Buy – $53.58). We were also able to upgrade on 3 Jul 08 (Long Term Buy – $44.00) after the stock had fallen 40% in six months, although the falls on that occasion were mostly market rather than stock-specific.

Of course, the difference between Cochlear and other fallen stars is that so far it has always recovered. But ‘so’ and ‘far’ are two pivotal words. What matters is what happens this time. So, is this another short-term blip or the start of something more sinister?

Market share losses

Cochlear’s current problems hark back to the recall of the Nucleus 5 implant in September 2011 (see 13 Sep 11 (Hold – $57.50)). Competitors seized the opportunity to build market share. In early 2011 Cochlear held 75% of the bionic ear market; now it’s about 60%.

The most significant beneficiary has been market No. 2 Advanced Bionics, which has come out the other end of its own recall with a much-improved product line-up, partly thanks to technology contributed by Sonova, which acquired the company in 2009 and owns the Phonak hearing systems business.

Cochlear's problems have been compounded by the launch of the Nucleus 6 processor, approval for which has already been granted in Canada and Korea, is imminent in Europe and is expected later in the year in the US.

Customers have been delaying implants and processor upgrades until the new model is available. This isn’t unusual. Ahead of the launch of the Freedom system in the second half of the 2005 financial year and the Nucleus 5 system in the first half of the 2009 year, unit sales slowed, as Chart 1 shows. Each time, they recovered with the launch of the new model.

There’s every reason that pattern will be repeated with the Nucleus 6. It appears to be another big step forward in processor technology and management is extremely upbeat about it.

As well as being smaller, highly water resistant and able to connect wirelessly to devices such as phones, computers and TVs (when the necessary software is ready), it can also be used as a 'hybrid' in tandem with an acoustic hearing aid to make full use of any residual hearing. But the Nucleus 6’s major selling point is that it is able to adjust automatically for six different sound environments, applying new noise cancelling and wind noise reduction technologies as appropriate. The Nucleus 5, by contrast, had fewer specific environment settings and they had to be selected manually.

Advanced Bionics’ Naida CI Q70 processor, launched earlier this year, is also smaller than previous models (although not as small as the Nucleus 6), water resistant, and wireless and hybrid compatible. It may even have an edge in terms of noise reduction, thanks to the integration of Phonak hearing aid technology. But it doesn’t offer the automatic environment sensing and adjustment of the Nucleus 6. With this likely to be a major differentiator, we’d expect a recovery in unit sales and market share as the Nucleus 6 gains approval around the world.

Upgrades

The new processor should also drive a recovery in processor upgrade sales. In the four years after the Freedom system launched in 2005, $250m was generated from upgrade sales, but the installed base of implant recipients – at about 200,000 – is now more than three times as large as it was back then. Following the launch of the Nucleus 5 processor upgrade in 2011, upgrade sales reached almost $100m in the first half of the 2012 financial year before fading away to not very much in the current half.

Medical insurers tend to limit how frequently people can upgrade their processors, so upgrades to the Nucleus 6 won’t come in a sudden rush. But it’s not hard to imagine upgrade sales hitting $200m a year over the next few years.

This demonstrates one of Cochlear’s key strengths; it can generate around a fifth of its revenue, and a larger portion of its profit, just by selling upgrades to people that have already received its implants. And this installed base is still increasing by more than 10% a year.

Margin pressure

Which brings us back to market growth. Of particular concern is the slow sales growth in developed markets, particularly the US (see Chart 2). Whilst offset in part by growth in the Asia-Pacific region, margins here are about 22% (including a share of central costs), compared with about 30% for Europe and the Americas. These customers are also likely to upgrade less frequently, especially in China, where sales are made on large Government tenders.

Deep recessions in the US and Europe haven’t helped but there’s also an element of market saturation. Sales are likely to recover somewhat but there’s no doubt that the shift to developing markets will continue, and margins will remain under pressure.

But who wouldn’t be happy with margins of 22% in their weakest markets and a return on capital employed of around 50%? These figures show how Cochlear remains a very high quality business. All that’s missing is some top-line growth. That should come over the next few years with the Nucleus 6 on its way, the US economy recovering and, most likely, a lower Australian dollar.

As ever, though, the shares are not cheap. With the price up 13% since we upgraded on 3 Jun 13 (Buy – $53.58) and up 5% since we reverted to Hold on 5 Jun 13 (Hold – $57.85), Cochlear is trading at about 38 times expected underlying earnings per share for 2013, excluding hedging gains.

But with the Aussie dollar at US$0.92, underlying 2013 earnings per share would be around $2.50, giving a PER of about 24. Assuming some organic revenue growth in 2014, the underlying PER would fall to around 22. That would be more like it. We’ll be looking for another opportunity to upgrade this excellent company below $55. In the meantime, HOLD.

Note: Our model Growth Portfolio owns shares in Cochlear.