Cochlear: Result 2016

If you're wondering – perhaps not for the first time – if I'm a moron for recommending 18 months ago that you sell Cochlear, rest assured, you aren't alone. I've been wondering the same thing.

The question raised by such an absurdly bad call, though, isn't about the quality of Cochlear or the little grey cells in my head; it's how can you tell whether an investing decision was wrong.

The 50% increase in share price isn't proof enough; 18 months is too short a timescale to remove the whims of the market. For example, we first recommended members buy Sydney Airport when it listed in 2002 and have held on ever since. Investors have endured two 20% falls along the way, and one 60% drop during the global financial crisis. These short-term price movements may have suggested we were wrong, but our long-term reasoning has been bang on and the stock is up sevenfold since our original Buy recommendation.

Cochlear, though, isn't unfolding how we expected, both in terms of its share price and the underlying business. And that tells us that our valuation was probably off.

In February 2015, we were disappointed by Cochlear's ongoing loss of market share to its smaller competitor Advanced Bionics, which had recently released the first wireless-enabled processor. Cochlear's unit sales fell 14% in the first half of the 2014 financial year and net profit plunged 79%. We thought it was a permanent loss of ground.

Now the situation is reversed. Cochlear's unit sales grew 12% in the year to June, with revenue up 23% to $1.2bn, or 12% after removing the effect of currency fluctuations. Advanced Bionics' revenue from implant sales, on the other hand, fell 2% in the year to March in constant currency terms. And, because Cochlear operates with relatively high fixed costs, the higher manufacturing volumes gave a boost to margins, with net profit up 30% to $189m.

Mature market?

The most impressive part of the result was 10% growth in the US, UK, Germany and Australia. These markets are all 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.

The way to grow in a mature market – as in any – is to offer something competitors don't have. And here, last year's release of the Cochlear Profile Series implant gave the company an edge. The Profile Series is the thinnest implant available of any competitor, and the electrode that's coiled within the patient's ear is less than half the size by volume of its predecessor.

When it comes to Cochlear implants, size really does matter. If you're a parent shopping around for an implant for your child, you want the thinnest implant available. Slim electrodes cause less damage to the ear and so are less likely to ruin any residual hearing. They can also be positioned more closely to the hearing nerve, which improves sound recognition.   

Research & Development

The company released several other new products during the year, including an off-the-ear processor, known as the Kanso, which can be worn discretely beneath the recipient's hair. The company also added two new processors to pair with its Baha bone conducting implants, which helped lift revenue 9% for the Acoustics product range (12% of total sales).

Spending on research and development (R&D) increased 12% to $143m, representing 12% of revenue. Management said it would be ‘injecting greater discipline into our R&D processes to ensure our investments are customer-driven and returns focused'.

We're not sure how that differs from what (we hope) they are currently doing, but it does tie in with statements made in February that suggest R&D spending would grow more slowly than revenue for the foreseeable future. The result should be an improving profit margin from the already juicy 16%.

Cochlear's R&D spending will still be meaningfully larger than that of its main competitor, Advanced Bionics, which is just a third of Cochlear's size and only spends around 8% of revenue on R&D. We aren't concerned by the R&D slowdown.

New Services division

As we explained in Cochlear: The perfect razor and blade, a Cochlear implant can remain for up to 70 years inside a patient's head – but that also means the patient is locked into a cycle of upgrading the external sound processor every few years. As the installed implant base grows, so too does the proportion of recurring earnings from processor upgrade sales.

Revenue from upgrades, repairs and accessories increased 20% in constant currency terms, and now represents 25% of total sales. This is up from 8% in 2010 and management said it expects the trend to continue as the installed base expands. Management has also opted for ‘Services' to be established as a separate business unit, and we welcome the move.

Management expects net profit of $210–225m in 2017 at current exchange rates, a 10–20% increase, and is targeting a dividend payout ratio of 70% of net profit. That puts the stock on a forward price-earnings ratio of 34 and a dividend yield of around 2%, using the midpoint of that range.

Even for a high-quality company, that's a steep valuation and the current share price factors in significant future growth. Whether Cochlear meets those growth expectations is what matters – and, with its formidable competitive advantages, economies of scale and large research budget, that goal isn't out of reach.

When we recommended you Sell Cochlear 18 months ago, we locked in a 58% gain since the previous year's upgrade. That's nothing to sneeze at, but we still underestimated the company's ability to turn itself around and that meant we left plenty of money on the table.

High-quality companies tend to give pleasant surprises rather than disappoint, and it's worth giving them extra leeway as they forge ahead. On that basis, we're making a step change to Cochlear's price guide and increasing our recommended Sell price from $100 to $150. We're still a long way from where we'd buy the stock (which itself rises from $65 to $75), but the new price guide combined with today's share price decline means we're upgrading to HOLD.