It’s a business model known, and hated, by men everywhere – the ‘razor and blade’. You buy a new razor with a smile on your face, having shrewdly compared the price and features of different brands. And then you have a small seizure every time you go back to the store to buy a pack of replacement blades.
The real money, as far as the manufacturer is concerned, is in selling you an ongoing supply of blades and accessories after you’ve been locked in with the relatively cheap razor. But the scheme isn’t foolproof. If you get tired of being gouged, you can start again with a competing brand.
At Cochlear’s investor day, held earlier this month, a presentation slide was titled ‘Creating customers for life’. That would be a far-fetched anthem for Gillette, but Cochlear means it literally.
Upgrade sales growing as a proportion of revenue
Nucleus 6 penetration is still low
Need more implant growth to justify price
A cochlear implant is a device that replaces the function of the inner ear for people with hearing loss. It’s surgically implanted in the patient’s head and has a lifespan of around 70 years, so there’s no taking it back to the store or swapping for a cheaper model. Cochlear implants are the ultimate ‘razor’.
The ‘blade’, in this case, is the external processor, which captures sounds in the environment and converts them to digital code before they’re transmitted to the implant. Depending on care, a processor will last several years and Cochlear offers a three-year warranty.
A typical ‘upgrade cycle’ would see around 50% of patients replace their processor every 5 years, which is partly due to health insurers limiting upgrades to one every 4–5 years. And at US$9,000 a pop, who can blame them.
This is an industry where regulatory barriers and the significant cost of research makes it difficult for new companies to get a foothold. Cochlear has only a couple of significant competitors – Med-El and Advanced Bionics – and all three companies are keenly aware that once a patient has had the implant, they’re locked in to paying for processor upgrades and accessories for many decades.
With this in mind, the companies try to differentiate themselves in terms of processor features and other services, such as repairs or help navigating the insurance scene. Cochlear, Med-El and Advanced Bionics compete on everything ... except price.
In the USA, a Cochlear implant costs around US$20,000 for the device and a further US$40,000 for the surgery. As mentioned earlier, a new processor costs around US$9,000, though they tend to be cheaper – sometimes substantially so – in most other countries. In any case, a lack of pricing pressure has allowed Cochlear to enjoy a gross margin of 70% over the past 12 months and – with few capital expenditure requirements – a return on equity of 46%.
More than 400,000 implants have been sold since the company’s founding and the current installed base is around 320,000, up from 100,000 in 2006.
Most people still think of Cochlear as a medical device manufacturer but 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 upgrade sales has risen from 8% in 2010 to 17% today.
Cochlear is gradually evolving into a service business and that’s good for shareholders. 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.
What’s more, management has said that engaged customers spend three to four times more on Cochlear products and accessories, so the company is focused on improving its social media presence, and is also hosting special events and increasing the outbound sales and marketing team to ensure constant interaction with customers.
Cochlear is a high-quality company, with increasingly sticky revenue and mouth-watering margins and returns on capital. But growth has been sluggish – revenue has only increased at around 7% a year over the past five years, and earnings per share have barely budged.
Still, every new implant brings with it a multi-decade stream of trailing revenue from processor upgrades, repairs and accessories. Since the release of the Nucleus 6 processor in 2014, around 20% of customers have upgraded. Assuming this reaches 50% in three years, another $450m or so of upgrade revenue should be earned over the next few years.
Implant sales are also improving and rose 12% in the six months to December. This was particularly encouraging given Advanced Bionics posted a sales decline over the period, implying Cochlear is increasing market share. However, Advanced Bionics is expected to release an ultra thin implant later this year that will compete directly with Cochlear's current model, so we expect the market share gains to slow or even reverse depending on its popularity. Until its release, it's hard to know what the reception will be.
Growth should also 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. However, the company’s extensive use of currency hedging (see page 9 of the interim results presentation) will partially mask the effect in the short term.
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. Management expects net profit of $180–190m in 2016, up 23–30% on 2015, or around $3.24 per share using the midpoint of that range.
Don’t get us wrong: as the company transforms into a service business, we expect Cochlear to be bigger and better ten years from now. However, a forward price-earnings ratio of 36 means you’re already paying for that growth, leaving little room for error, and the soon-to-be-released Advanced Bionics model risks derailing Mr Market's optimism if it proves to be a hit. There are better opportunities on our Buy list and we continue to recommend you SELL.