Cochlear: Interim result 2013

They say it can take years to build a reputation and seconds to break it, and so it seemed with Cochlear in September 2011, when the company announced the recall of its Nucleus CI500 range and saw its share price tumble 40% to a low of $45.75.

Helped by its frank and professional approach to the crisis, however, the company’s reputation with investors underwent a rapid rehabilitation during 2012, with the share price recovering to near-record highs of more than $80 ahead of Tuesday’s half-year result – giving it a price-earnings ratio of 27 times this year’s forecast earnings.

The market was betting on Cochlear’s customers cutting it the same sort of slack, enabling a return to the glory days of the past decade. But the message from the half-year result is that, at best, the jury is still out. At worst, the recall has enabled competitor Advanced Bionics to steal a march on Cochlear and the market dynamics will never be the same again.

No wonder the share price has tanked – by about 14% since the result, to $70.00.

Devil in the detail

Overall the result was fairly flat, with revenue up 9% in constant currency terms (up 1% in reported currency), earnings before interest and tax flat (excluding 2011’s product recall costs) and net profit (again excluding 2011’s recall costs) down 3%.

As if that’s not bad enough, for a company on a PER of 27 coming off a disastrous year, there was more devil in the detail – or perhaps more pertinently the lack of it. Unit sales grew 27%, but alongside the flat revenue growth, the only conclusion one can draw is that the average selling price was lower.

This is supported by strong revenue growth – of 33% in constant currency terms – in the lower-priced Asia Pacific market (which includes China), while the higher-priced American and European, Middle East and African regions struggled, with constant currency growth of 1% and 7% respectively.

Somewhat surprisingly, given the lower unit selling price, margins remained flat, suggesting that the company was able to operate off a lower cost base in the Asia Pacific. But that’s a somewhat hollow victory for a company that has always prided itself on being the market’s premium supplier.

Given that the Nucleus 5 was a new top of the range product, the strong suspicion has to be that its recall has damaged the company’s reputation in the Americas and Europe. Advanced Bionics, who recently re-entered the market following a recall of its own, has no doubt been taking advantage. Management was unable to say when it would be selling the Nucleus 5 again, but when it returns it may not be as popular as before the recall.

Margins worries

One concern from the presentation was that management suggested it could improve margins over time by increasing its research and development expenditure more slowly than revenue. For a company that’s just suffered a serious product recall, that seems like an odd strategy – more rather than less R&D might be the way to go. Perhaps the company is already sensing some pressure on margins.

With a gross margin of 73% and an EBIT margin of 28%, there’s a long way they could fall if the competition really heated up.

All this is said very much in a glass-half-empty doom-mongering kind of way, but that’s the way you’ve got to look at a stock that’s still priced on a PER of 26 despite the price falls yesterday and today.

We’d be keen to recommend Cochlear again, but we’ll need a cheaper price, or much better evidence that its market positioning remains intact, before we do so.

We nudged our price guide higher following last year’s full-year result, on 7 Aug 12 (Hold – $63.00) and, whatever the market might think, we remain happy with those numbers. HOLD.

James Carlisle and Jason Prowd.

Note: The Growth portfolio owns shares in Cochlear.