Cochlear: Result 2018

Sometimes it isn't so much what managements say that grabs your attention as what they don't say. 

In 2014, Cochlear announced a significant upgrade to the implant electrode, named the Profile Series, that made it less than half the size of previous electrodes. The thinner form reduces damage to the ear and leads to better hearing quality. Profile was a dynamite product, giving Cochlear a clear advantage over its competitors and has underpinned implant growth ever since. 

Cochlear's research and development (R&D) pipeline typically moves in cycles. Every 4–5 years, the company releases an external processor upgrade, and roughly the same amount of time passes between upgrades to the internal components, such as the electrode. 

It's now been four years since the last major upgrade to the internal device, yet Cochlear's largest competitor, Advanced Bionics, received regulatory approval in the US for its own ultra-slim electrode late last year, removing some of Cochlear's competitive advantage. We were hoping to see a new product launch this annual result, or at least hear more about what's in the pipeline. Instead, management was silent, pointing to the continuing growth in Profile sales. 

While the lack of new products was disappointing, we expect something new to be released in the next year or so. We're also pleased to see Cochlear not slacking off on the research front – the company boosted its R&D spending 10% this year to $168m, or around 12% of revenue. Given that Advanced Bionics only earns around $300m a year in revenue, it's safe to assume Cochlear's research budget is many multiples of its competitors'.

Implants strong

Overall, Cochlear had a good year. We were especially pleased to see solid growth in implant sales, which rose 8% to 35,260 units. Excluding Chinese Government tenders, which are large and erratic, unit sales rose 11%.

The best part was that growth was achieved across the board – Western Europe, the USA and other developed markets had a 9% increase in sales, and emerging market sales rose 15% after adjusting for the Chinese tenders mentioned above. 

Besides research, implant sales are the figure we're most interested in because when Cochlear makes an implant sale, it gains a customer for life. Every implant sale comes with a multi-decade stream of cash from processor upgrades that will far exceed even the high price of the implant itself, which runs at around US$20,000.  

Revenue from implant sales rose 8%, matching growth in units, which was good to see as it suggests average selling prices have stabilised after a 5% decline last year. Total revenue rose 9% to $1.3bn after removing the effect of currency fluctuations.

Revenue from services – which covers upgrades, repairs and accessories – rose 15% in constant currency terms, driven by the release of the Nucleus 7 Sound Processor. 

Services revenue accounts for 26% of total sales, up from 8% in 2010, and we expect that slice to increase along with the installed base of implants, which passed 500,000 earlier this year. Cochlear now has 100,000 members of its ‘Cochlear Family' club, which offers members special promotions and personalised support. 

Profit growth

Manufacturing efficiencies and lower repair expenses due to the centralisation of repair workshops helped boost the gross margin from 71% to 73%. While sales rose 9%, direct production costs rose only 1%.

Unfortunately, most of that benefit was lost on a 14% increase in administration and general expenses, so net profit rose ‘only' 10% to $246m. Free cash flow also took a hit, falling 8% to $216m due to a rise in capital expenditure associated with higher investment in equipment and a new IT system.

As we explained in The truth about Cochlear's market share, the company has a total potential market of around 7.5 million people. Just over half-a-million people worldwide currently have a Cochlear-branded implant, so the company has a penetration rate of around 7%. What's more, the total number of patients requiring cochlear implants is growing steadily at around 2–3% a year.

With this in mind, it's easy to imagine sales and earnings growth continuing in the high-single digits over the long term, and there's room to exceed this if Cochlear increases its market share or margins benefit from operating leverage.

Management expects net profit of $265m–275m in the 2019 financial year, an increase of 8–12%, putting the stock on a forward price-earnings ratio of 41 using the midpoint of that range. 

Cochlear continues to post impressive sales growth, it has a clean balance sheet, a dominant, growing market share, mouth-watering margins and plenty of free cash flow. It also has 500,000 or so lifetime customers who are locked into buying processors for several decades. As far as high-quality companies go, it's hard to do better. 

Nonetheless, a price-earnings ratio of 41 leaves little room to misstep and investors are paying up for growth that may not materialise, no matter how remote that possibility seems. 

We're raising the price guide to reflect the growing business, but the stock is trading close to our recommended Sell price. If Cochlear has become a large position for you, we recommend taking profits and ensuring a portfolio weighting below 7%. Other than that, Cochlear continues to be one of Australia's best healthcare stocks and we're sticking with HOLD.