Cochlear: Interim result 2017

As far as sustainable competitive advantages go, they don't get much stronger than Cochlear implants. Once the device is surgically embedded into a patient's head, it remains there for decades – up to 70 years in fact. Patients are then locked into a perpetual ‘upgrade cycle' of replacing the external processor, which captures sounds in the environment and converts them to digital code before they're transmitted to the implant. 

As you may have guessed, sales of the implants themselves are a much bigger deal than processor sales. Cochlear earns a higher margin on selling processors because customers have little negotiating power over prices once the implant is in their head, but selling an implant today means Cochlear has gained something far more valuable: a customer for life. That implant comes with a multi-decade stream of cash flows that will far exceed even the high price of the implant itself, which runs at around US$20,000.  

With this in mind, it was pleasing to see implant sales rise 10% in the six months to December, or 16% after excluding large tender sales to the Chinese government, which occur at irregular intervals. Most impressive was that the growth was achieved across the board – Western Europe, the USA, and emerging markets all grew sales by around 10%, with Latin America and Eastern Europe also showing improvements.

Management singled out two new products as drivers of the result: Kanso, an off-the-ear processor that can be worn discretely beneath a recipient's hair; and the new Profile Series implant, which has an electrode less than half the volume of its predecessor and is now the thinnest implant available on the market. Slim electrodes cause less damage to the ear and so are less likely to ruin any residual hearing, which makes the Profile Series particularly attractive relative to competitors.

Price declines

The result wasn't all peaches and cream, however. Although the number of implants sold increased 10%, revenue from implants rose a more modest 4%, or 8% after removing the effect of currency fluctuations, so average selling prices must be coming down.

It was also disappointing to see the company's recently renamed Services division – which covers upgrades, repairs and accessories – increase revenue by only 3% in constant currency terms. This is a sharp turnaround from the 20% growth achieved during the 2016 financial year, which suggests sales of the Nucleus 6 processor are starting to cool after two years of mammoth growth following its release. Still, Services revenue represents around 24% of total sales – up from 8% in 2010 – and we expect that proportion to continue to increase along with the installed base of implants.

The company's Bone conduction and Acoustic implants segment picked up some of the slack with revenue increasing 20% thanks to the new Baha 5 Power and SuperPower systems, which are the smallest bone conduction implants available for people with conductive or mixed hearing loss. The Baha 5 system is also the only product on the market that allows for direct streaming between an iPhone and the processor. Ultimately, though, bone conducting systems are a side show to regular implant sales and represent only 14% of revenue.

Cost controls

Overall, revenue grew a healthy 8% to $604m after removing the effect of currency fluctuations. Pleasingly, sales grew faster than costs, with administration expenses up just 6% and direct manufacturing costs falling slightly as a proportion of revenue. Spending on research and development also increased only marginally to $128m, representing 12% of revenue.

A growing top line plus minimal cost inflation combined to produce a 25% increase in Cochlear's earnings before interest and tax (EBIT) to $156m, for a margin of 25.7% compared to 23.5% last year. Net profit rose 19% to $111m.

What's more, a reduction in cash taxes paid and interest expense – along with the strong operating result – led to a 50% increase in Cochlear's free cash flow to $85m, which was partially used to reduce net debt from $118m to $93m. Management noted that a change to tax concessions for research and development spending will shave around $1.5m from net profit in the 2017 full-year result compared to 2016.

The company expects net profit of $210–225m in the 2017 financial year, an increase of 10–20%, putting the stock on a forward price-earnings ratio of 34. Cochlear is almost three times larger than its nearest competitor, has powerful economies of scale, a clean balance sheet and mouth-watering margins. We're increasing the price guide and continue to recommend that you HOLD.