Cochlear: Interim result 2014

After bottom-of-the-table Fulham scored in injury time to snatch a draw at Manchester United on Sunday, new manager David Moyes declared that it was ‘as bad as it gets’. United fans will want to believe him, but on recent form they will find it hard.

The underlying message from Cochlear chief executive Chris Roberts on Tuesday was that the company’s latest half was as bad as it gets, but investors are evidently finding it hard to keep the faith and the stock closed the day 9% lower.

The main drag in Cochlear’s latest figures was again people holding back from implants and upgrades due to the impending launch of the Nucleus 6 processor. We saw this in the second half of the 2013 financial year, but since approval was still to be granted in the US and other key markets, the weakness continued throughout the half, and indeed it was worse than expected.

Although the N6 was granted basic approval and started shipping in the US in October, it had to do so without various important features, such as rechargeable batteries (approved in December and began shipping in January) and the all-important SmartSound IQ (which automatically senses and adjusts for different sound environments and which is still not approved).

US market share falls

Cochlear’s market share fell to 60% in the US according to its own estimates – although the company said it believed the losses were limited to the US and 'not a global phenomenon'. Total implant unit sales fell 14% to 11,712. The comparison was made worse by the absence of any Chinese government contract wins, which added about 1,800 in the first half of 2013. Excluding that contract, unit sales were flat.

Despite all this, sales revenues edged up 2% to $377m, but that was helped by the fall in the Australian dollar (to an average of US$0.93 in the period, down from US$1.03) as most of Cochlear’s sales are denominated in US dollars. In constant currency terms, sales revenue fell 8%.

The flipside of the falling Aussie dollar, however, is that the company had to pay out on its currency bets (er, sorry, hedges). In all, the company lost $6m on these in the half, compared to a win of $24m in the prior period, and this saw total revenues down to $371m.

Because the company operates with relatively high fixed costs, the lower manufacturing volumes sent the gross margin down from 78% to 66%, resulting in a 4% fall in underlying gross profit (ie excluding currency effects).

It didn’t get any better at the operating level, where selling and general expenses rose 17% despite the sluggish sales. As Chris Roberts explained it, the company has spent $500m over the past five years developing its new range of products and it's not now going to do a poor job of launching them for want of some marketing dollars. We hold our breath, and say 'fair enough'.

Not skimping on R&D

The company was also not skimping on research and development, increasing expenditure by 9% to $65m – a remarkable 17% of sales revenues. In the conference call it was put to Roberts that he’d previously said that R&D could be cut back to support margins in tough times, and that these were tough times.

‘We could slash and burn R&D, but that is really not something that I’ve ever wanted to do’, he replied, before adding that the company was ‘holding its nerve’ and expected to get the percentage spend on R&D back to ‘where we want it to be’ by increasing revenues.

All in all, the company made underlying earnings before interest and tax of $55m before hedging losses, down 35%. After $6m of hedging losses, a provision of $23m for the recent US patent ruling and $5m in net interest, profit before tax was $27m, net profit was $21m and earnings per share were a desultory 37 cents.

So that's the bad news (except for the bit about R&D). The good news, is that the company saw a significant uptick in the second quarter, helped by the US N6 release, with sales rising ‘30% plus’ and margins improving. This was supported by the fact that Europe, which has had the N6 approved for the longest, was the strongest performing region.

With ‘sales momentum going into the second half’, further product approvals (including that of the Nucleus Hybrid), a Chinese government contract for 1,800 units, and another strong performance from bone-anchored (BAHA) devices, the company provided guidance for $70-80m of net profit in the second half, to take the full year total to about $90-100m. Excluding hedging losses and the provision of $23m for the US patent decision, that’s likely to be closer to $130m, implying underlying earnings per share more like $2.30.

Still a growth company

That puts the stock on a current year price-earnings ratio of about 23, but that’s based on very depressed earnings. Taking the second-half run rate of $85m (before $10m of hedging losses), the company could make an underlying $170m in 2015, which would mean earnings per share of about $3, before hedging losses.

There are plenty of potential swings and roundabouts in this number, because the current half is unlikely to be representative: on the one hand it includes a chunky Chinese government contract, but on the other the company is still ramping up with new products, including the N6 in key regions. Movements in the Aussie dollar will also affect underlying profits. But something close to $3 is certainly not hard to imagine and would put the stock on a forward PER below 20.

That doesn’t look at all bad for a high-quality growth company and, despite all its recent problems, Cochlear is still that. Chris Roberts was brooking no argument in the results presentation: 'I know that when you see these [sales] charts again after the second half, you'll agree that Cochlear is a growth company'.

Leaving the hyperbole aside, when asked what gave him confidence about future industry growth, he observed that adult penetration rates in Australia are around double their level in many other developed markets, suggesting that there’s still plenty of growth to go for in these other territories. Awareness is the key to getting it, he felt, and we expect the market to continue to develop in that regard.

The board underlined its confidence by matching last year’s full-year payout with an interim dividend of $1.27 (unfranked, ex date 28 Feb). The plan is to keep that constant, while earnings catch up to return the payout ratio to 70%.

But the proof of the pudding will be in the eating. Manchester United have brought in Spanish star Juan Mata to arrest their decline, while Cochlear is pinning its hopes on the Nucleus 6. We have more confidence in the latter, but there could be more twists and turns along the way.

For this reason, we recommend that you keep a close eye on your portfolio weightings: our recommended maximum is 7%, but it would make sense to start low to leave room to invest more if the price falls further. With that caveat, and with the price up 4% since Cochlear under review after weak first-half result on 11 Feb 14 (Buy – $52.98), we’re upgrading to BUY.

Note: Our model Growth Portfolio owns shares in Cochlear.

Note: Whether you pay $54 or $56 isn't going to matter in the long run, so we won't consider officially downgrading the stock until the share price is a dollar or two over $55. Cochlear remains a high quality business and we don't mind paying a fair price for it.