Cochlear: Result 2017

Three years ago, Cochlear was famous for three things: declining sales, declining margins, and declining market share. What a difference three years can make.

Cochlear implant sales rose 8% to 31,554 units in the year to June, or up 14% if you exclude Chinese Government tender sales, which are large but sporadic. Revenue from implants – 62% of the total – grew 10% after removing the effect of currency fluctuations.

Though that's a perfectly respectable figure, it does mean that average selling prices declined for the first time in recent memory, due to a shift in sales to lower priced regions and slight price reductions.

Developed markets

Revenue from the Americas rose an impressive 14% to $595m, or 18% in constant currency terms. The result was buoyed by a 15% increase in sales to the high margin but relatively mature US market.

The popularity of Cochlear's new Kanso off-the-ear processor was a major contributor, as was last year's introduction of a new ultra-thin electrode. Historically, a drawback of receiving a cochlear implant has been that the patient often loses any residual natural hearing due to damage to the inner ear during surgery. However, the new smaller electrodes are less damaging, which is especially important when the recipient is a child. Cochlear has the thinnest electrodes currently on the market, though competitors have their own versions awaiting regulatory approval.

Although Cochlear is by far the largest in the industry – it's three times larger than Sonova's cochlear division, the second largest – it was pleasing to see it increasing its market share. Sonova reported a 2% decline in cochlear implant sales for the year to March – and forecasts sales growth of 4–6% for 2017 – compared to Cochlear's double-digit growth.

The company's Bone conduction/Acoustic implants segment also had a strong year with revenue increasing 26% thanks to the new Baha 5 range of processors. Ultimately, though, Acoustic systems are just a sideshow for Cochlear and account for only 13% of sales. Traditional implant sales, which lock customers in and provide a recurring revenue stream thanks to processor upgrades, are the big bread winner.

Services and Nucleus 7

Thankfully, lots of bread was won this year. The company's Services division – which includes processor upgrades, batteries and accessories – increased revenue by 10% due to the ongoing popularity of the Nucleus 6 processor. Sales picked up speed as the year progressed and clocked 17% growth in the second half. Around 40% of customers in developed markets have now upgraded to the Nucleus 6.

Spending on research and development (R&D) rose 5% to $152m, representing 12% of revenue. R&D spending is expected to be $160m–170m in 2018. Assuming revenue continues to grow in the double digits, the slower growth in R&D costs means more of each sale will fall to the bottom line and margins should improve.

When R&D spending shrinks as a proportion of sales, it can sometimes be a red flag that management is seeking a short-term boost to net profit. However, as Cochlear's R&D spending is still meaningfully larger than any of its main competitors, we're not too concerned.

In July, the company announced the new Nucleus 7 processor, which is the first to let users stream music and sound direct from their iPhone or other Apple products. The device has been approved by regulators and will be released to the public in September. It's bound to be a hit, though Sonova also recently announced phone connectivity for its next generation processor, so it may be a short-lived competitive advantage.

Management expects net profit of $240m–250m for the 2018 financial year, an increase of 7–12%. That puts the stock on a forward price-earnings ratio of around 36. Undoubtedly, Cochlear is one of the priciest healthcare stocks around, but making the case that it's overvalued is much harder. We're raising the price guide and, with formidable competitive advantages, economies of scale, and a solid research pipeline, we're sticking with HOLD.