Cochlear: Result 2019

Selling Cochlear implants is vital to the company's future. But the real money is in selling you an ongoing supply of processor upgrades and accessories. A good thing too, given this year's result.

More than 550,000 implants have been sold since the company's founding. As the installed base grows, so too does the proportion of recurring earnings from processor upgrade sales, repairs and accessories. The proportion of revenue from these services has risen from 8% in 2010 to 30% today.

Once a patient has the implant, there's no switching brands. Upgrade processor sales are high margin and recurring - albeit relatively cyclical as people tend to put off upgrading their processor if they know a new model is going to be released soon. 

Upgrade revenue increased 17% this year after removing the effect of currency fluctuations due to the popularity of the Nucleus 7 Sound Processor. The Nucleus 7 is the only processor on the market that can stream sound directly from an iPhone to the processor - it doesn't get more futuristic than being able to beam a phone call straight to your brain without any sound hitting the air. 

Emerging pain

The strong revenue from the Services division offset a poor year of implant sales. Revenue in developed markets was flat and management noted a loss of market share - though sales returned to growth in the final three months of the financial year after the company released the ultra-thin Profile Plus series of implant. 

Although implant sales were lacklustre in Europe and the US, the real disappointment came from emerging markets. There were 'significant declines' in Turkey and Argentina as well as 700 fewer units sold during the annual Chinese government tender. Overall implant revenue fell 3% in constant currency terms.  

The company's Baha bone conducting implants and Acoustics products also performed poorly with revenue falling 1%, though the division only accounts for 12% of sales. Management was optimistic about next year's planned release of the new OSIA product improving sales.

Total revenue grew 2% to $1,446m, while earnings before interest and tax (EBIT) increased 5% to $370m due to an increase in research spending being more than offset by a decrease in administration costs.

Net profit increased 11% to $277m due to a decrease in interest expense on the company's debt. Net debt has fallen from $181m to $103m over the past five years. And because sales and profits have grown, operating earnings now cover interest payments 80 times over. It's a wonder management doesn't just pay off the last sliver of debt for the glory of saying Cochlear has a pristine balance sheet.

Currency kicker  

While implant sales were sluggish this year, the release of the new Profile Plus should help developed market sales rebound. There's also a good chance that the company will release a processor that can stream to Android phones in the next couple of years, which would further boost upgrade sales. We expect the minor loss of market share this year to be regained quickly.

What's more, growth should get a free kick from the lower Aussie dollar because more than 90% of Cochlear's sales are made in foreign currencies, yet its costs are still mainly in Australian dollars. 

The Australian dollar has declined from 73 to 68 US cents over the past year. As Cochlear renews its foreign exchange contracts at lower rates, earnings should rise faster than sales - though they will still tend to be bumpy due to the upgrade cycle and bulk purchases by governments. At current exchange rates, Cochlear's management expects net profit of $290m-300m in 2020, an increase of 9-13%. Using the midpoint of that range, the stock trades on a forward price-earnings ratio of 41.

Cochlear is a high-quality company with sticky revenue and excellent margins and returns on capital. Every new implant brings with it a multi-decade stream of trailing revenue from processor upgrades, repairs and accessories. However, its price-earnings ratio of 41 means you're already paying for significant future growth. There are better opportunities on our current Buy list, although we're sticking with HOLD.

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