Cochlear: Interim result 2016

This time two years ago we upgraded Cochlear, believing it was a high-quality growth stock hit by a temporary setback as people held out for the latest model (see Cochlear: Interim result 2014 (Buy – $54.64)).

That investment case has played out, though it's starting to look as though we left some money on the table. Total revenue rose 32% in the six months to 31 December to $581m, or 16% after removing the effect of currency fluctuations.

The number of Cochlear implants sold increased 26% to 14,748 units and benefited from a large Chinese government tender of 1,700 units. After removing the Chinese tender, unit sales still increased a respectable 12%.

Processor upgrade sales rose 16% in constant currency terms, with the company's latest sound processor – the Nucleus 6 – proving popular. Cochlear expects upgrade sales to be strong for the next few years.

The Nucleus 6 is the smallest processor on the market and has many advanced features like being able to connect wirelessly to smartphones and TVs. Only 20% of implant recipients have upgraded since its release last year, so there is still plenty of room for the rollout to continue. A typical upgrade cycle would see 50% penetration after 4–5 years. 

The company's Baha bone conducting implants and Acoustics products also performed decently with revenue increasing 9% to $72m. The new Baha 5 SuperPower sound processor was released in Europe in December and is awaiting regulatory approval in other markets.

Revenue from the high-margin US market increased 11% in constant currency terms to $264m (46% of total revenue). The result was driven by a 10% increase in implant sales – no easy feat in a mature market. Management said that Centers for Medicare and Medicaid Services's (CMS) recent increase in reimbursement rates for implants had a 'huge' impact – not too surprising, given that a Cochlear implant costs as much as a new Volkswagen Golf. 

Revenue from Europe, the Middle East and Africa rose 8% to $210m, while sales in the Asia-Pacific grew 55% to $107m. This was mainly down to the large Chinese tender mentioned above, but Australasian revenue still managed a 12% increase.

Gaining market share

Cochlear achieved strong growth in all markets. More importantly, perhaps, one of its largest competitors didn't.

Advanced Bionics, owned by Swiss-based Sonova, posted a lousy interim result for the six months to September, with sales declining 11% in local currencies to CHF85m (around $124m). The company also said at its interim result that it sees the overall implant market growing in the 'mid-single digits'.

Cochlear is by far the largest in the industry, with a market share of around 60%. Until last year, however, Cochlear was losing market share to Advanced Bionics but, with the Nucleus 6, that trend seems to be reversing.

Unfortunately, it may be short lived. In August, Advanced Bionics gained US approval for its new Q90 sound processor. The Q90 combines a cochlear implant with acoustic amplification of a patient's natural hearing, making it a direct competitor to the Nucleus 6, which also has a hybrid option. Both devices have similar features and dimensions so it will likely be a strong competitor. We're keen to see Sonova's full-year result in May to learn how the new units are performing.

Research and Development

Though Advanced Bionics' Q90 poses a clear threat, Cochlear isn't resting on its laurels. We were pleased to see research and development (R&D) spending increase 14% on the prior year.

'Innovative technology was the key driver of Cochlear for the last 30 years … As you know, we spend close to $100 million on R&D to make sure that we have a competitive advantage in the marketplace ... we're two to three times larger than our next closest competitor but it's also about identifying new indications from an innovation perspective,' said chief executive Chris Smith.

Management also pointed out that only 5% of people have access to Cochlear's technology. Management said this mainly comes down to awareness and access to clinics, and so is investing heavily in marketing programs. Selling and administration expenses increased 29%.     

Earnings upgrade

Cochlear's earnings before interest and tax (EBIT) rose 30% to $131m, while net profit rose 32% to $94m.

A lower Aussie dollar benefits Cochlear more than almost any stock on the ASX bcause the company earns more than 90% of its revenue in foreign currencies, yet incurs most of its costs in Aussie dollars.

The full impact is likely to be masked in the short term by the company's extensive use of currency hedging but Cochlear's net profit still received a $16m boost this half due to foreign exchange movements. If the Aussie dollar remains low, we expect the company to benefit as hedging contracts are renewed at lower rates.

Management expects net profit of $180m–190m in 2016, up 23–30% on 2015. Previously, management had expected $165m–175m with the upgrade mainly down to the lower dollar, rather than an improvement in underlying performance.

All up, this was a great result. But as Benjamin Graham would say: stocks have prices, companies have value. We frequently get questions along the lines of 'how can you possibly recommend selling Cochlear, it's such a great company'. We couldn't agree more with the latter. But for Cochlear to also be a great investment, you need to buy at a reasonable price.

The stock is up 21% since Cochlear: Result 2015 from 12 Aug 15 (Sell – $85.25). We're increasing the price guide to reflect the bumper half and improving outlook, but with the stock on a forward price-earnings ratio of 32, the current share price leaves no margin of safety. SELL