Cochlear: Interim result 2018

A year ago, Cochlear reported strong growth in implant sales and sluggish revenue growth from processor upgrades – but it seems to have gone into reverse for the six months to December.

The number of implants sold fell 2% to 15,972 while upgrade revenue rose 12%. The decline in implant sales was disappointing but it hides a positive geographic trend: the US market increased sales by 15% and Western Europe by 9%.

These markets are both considered ‘mature', where Cochlear has had a long-term presence and market growth is generally slow but stable in the mid- to high-single digits. Cochlear is increasing its market share despite already being three times larger than its nearest competitor, Sonova.

The good result in developed markets was unfortunately offset by poor sales to emerging markets. However, management said the decline is a temporary effect due to the timing of large government tenders. Unlike most developed markets, where private health insurers are Cochlear's main customers, developing countries have large tenders where governments buy in bulk.

China is a case in point. The comparable period last year benefited from 1,100 units purchased by the Chinese Government, which wasn't repeated this half. However, in October the Chinese Government purchased 1,491 units, which Cochlear will begin shipping in the second half of the financial year. That is, demand is increasing but the timing of purchases makes earnings from the region lumpy. Nonetheless, emerging markets offer significant growth potential as disposable incomes rise and more people can afford Cochlear implants, which typically cost as much as a small car.

Services

It was pleasing to see the company's Services division – which covers upgrades, repairs and accessories – increase revenue by 12% in constant currency terms. This is a sharp improvement from the 3% growth achieved last year, which suggests the new Nucleus 7 processor is gaining traction.

The Nucleus 7 has features befitting a sci-fi movie – namely the ability to stream music and calls directly from an Apple device to your brain using only electrical signals and a Bluetooth connection. No sound required.

Patients love the innovative connectivity options, but it's worth noting that they also add a new, spine-chilling risk: what if someone figures out how to hack into the Nucleus platform or releases a phone virus that causes deafening noise, complete silence or – dare we suggest – some form of advertising.

We aren't software experts and no doubt security is at the front of management's mind, but we do know that a software-driven medical device implanted in someone's head offers all kinds of catastrophic possibilities. Hopefully it's a tiny risk, but one still worth considering given it could destroy the company's reputation overnight.

Pre-tax profit

Total revenue rose 7% to $640m after removing the effect of currency fluctuations but net profit was up a paltry 1% to $111m. The main anchor was a 16% increase in sales, marketing and administration expenses. The increase relative to sales was disappointing, but the extra dollars spent appear to be winning over plenty of customers given Cochlear's growing market share.

Cochlear implants remain in a patient's head for decades, locking them in to repeat purchases as they upgrade their external processor. Furthermore, the industry has tremendous economies of scale in manufacturing and research. At least in theory, the biggest player should be able to make the best products for the lowest price and still take home the most profits. Winning that initial implant sale is paramount. With this in mind, we're happy to forgo a little profitability upfront if it means strengthening the company's competitive advantages and long-term earnings.

A second anchor on profit growth was a $5.5m one-off revaluation of the company's deferred tax assets due to December's reduction in the US corporate tax rate from 35% to 21%. This shaved 5% from net profit but the lower corporate tax rate will benefit shareholders over the long term.

Management expects net profit of $240m–250m in 2018 at current exchange rates, a 7–12% increase, which includes the effect of US tax changes. That puts the stock on a forward price-earnings ratio of 40 and a dividend yield of 1.6%, using the midpoint of that range.

Cochlear's formidable competitive advantages, economies of scale, and significant growth potential over many decades deserve a premium price, but even the best company isn't worth an infinite sum.

Whether Cochlear meets the growth expectations built into its current share price is what matters. We don't see anything gloomy on the horizon but it's the ‘unknown unknowns' we worry about. If Cochlear is a large position for you, we strongly recommend taking some chips off the table to ensure a maximum portfolio weighting below 7%. Other than that, this was another good underlying result and we're notching up our price guide slightly. HOLD.