For investors interested in Cochlear, the plan to ‘Buy low, sell high’ is long forgotten. The strategy that replaced it – ‘Buy high, sell higher’ – has also been discarded. Now, fans of the hearing implant maker just scream ‘Buy, buy, buy!’
Though the stock is near its all-time high, Cochlear bulls do have a point. Profits have more than doubled over the past three years. What’s more, the company estimates that the market for cochlear implants is growing steadily at 8–10% a year, with Cochlear enjoying a rising market share that already tops 60%.
But there’s a black hole at the heart of Cochlear. It adds complexity, mystery, and the company’s future depends on it in every way: research and development (R&D).
Biggest R&D budget in industry
Kanso and Profile Series are popular
Watch out for 'upgrade cycle'
Cochlear is the industry’s largest investor in R&D, spending $144m in 2016. The company has over 100 collaborative research programs across 20 countries and it spends twice as much as its closest competitor, Sonova, based in Swizerland.
For good reason, too: today’s R&D spending is better thought of as a precursor to tomorrow’s sales. As you can see in Chart 1, the steep run-up in spending between 2010 and 2013 as the N6 speech processor was being developed was followed by a large jump in sales growth over the following three years.
You may be wondering whether the downward trend in R&D since 2014 is a bad sign, but we don’t think so. R&D spending has grown 15% in dollar terms; it’s just that significant sales growth outpaced it – which speaks to Cochlear’s strong economies of scale and operating leverage.
Though vital, R&D spending does have diminishing returns, so we expect it to trend downwards as a proportion of sales as Cochlear grows.
Once a patient has a Cochlear device surgically implanted in their head, there isn’t an option to switch brands. Customer captivity is rock solid, so every time a recipient wants to replace or upgrade their external processor, Cochlear is assured another sale.
This point isn’t lost on the company, nor its two main competitors, Sonova and Austria-based Med-El.
Given the long stream of recurring revenues that come with new customers, the initial sale is paramount. Having the most advanced and comfortable implant and processor on the market is essential to building support from doctors and audiologists.
Thankfully, Cochlear is well ahead of its peers on this front, with two products leading the charge: the new Profile Series implant, whose electrode is less than half the volume of its predecessor's. It’s the thinnest implant available on the market, which makes it particularly attractive to patients with residual hearing because slim electrodes cause less damage to the ear.
Then there’s the Kanso speech processor, Cochlear’s first off-the-ear processor, which can be worn discretely beneath a recipient’s hair. Kanso was released in Europe and the US late last year and was a key driver of the company’s 10% uptick in sales for the six months to December. Kanso will be available worldwide by the end of the 2017 financial year.
It’s tempting to assume precision and performance are the only thing that matter when it comes to choosing an implant and processor, but this isn’t the case.
In the late 1990s, Cochlear was forced to switch from making bulky processors that would sit in a patient’s pocket (think original iPod) to behind-the-ear processors. The reason is telling: despite inferior processor performance of the behind-the-ear model, it was the only one teenagers were willing to buy. The pocket processor, with its wires to the head, was, quite simply … too ugly. Cochlear has always been ahead of the curve when it comes to aesthetic design, and the Kanso – which resembles a key-fob – is the next generation of that lineage.
Speaking of generations, the Kanso’s timing is no coincidence. If you’ve been following Cochlear for a while, you may remember sales skipped a beat in 2013. The new N6 speech processor was due for release that May and, in the 12 months preceding it, there was a significant decline in processor sales – upgraders delayed buying the current model in anticipation of something better.
The sharp decline in sales caught investors off guard and the stock promptly fell 30% – which, without coincidence, preceded our most recent upgrade to Buy on 12 Feb 14 (Buy – $54.64).
Though we’d be happy to see another buying opportunity, management doesn't want to make the same mistake. It has been quite clear in labeling the Kanso a ‘mid-cycle’ processor, presumably in an effort to push out customer expectations for the next generation N7 processor.
Insurers typically limit processor upgrades to once every five years (and, at US$9,000 a pop, who can blame them). This creates an ‘upgrade cycle’, which has become stronger as upgrade sales have grown as a proportion of total revenue.
Recipients of the N6 will be eligible for upgrades beginning May 2018 and, if the next generation isn’t released before then, we could see customers again defer the replacement of their processor – which would cause another drop in sales. We suspect management will push to release the new N7 by the end of the year to ensure it doesn’t repeat 2013’s fiasco. If it doesn't, investors should prepare for some slowing sales growth.
Taking a feather from ResMed’s hat, Cochlear has acquired San Francisco-based Sycle, the world’s largest provider of cloud-based practice management software for audiologists. Sycle software is used by 20,000 audiologists across the US, Canada and the UK, with a 70% market share in the US.
The software provides many services, such as practice financing, insurance reimbursement, marketing and the management of patient data. It’s a curious purchase and, at best, seems to lie on the blurry edge of management’s ‘circle of competence’.
It isn’t totally clear what strategic merit the acquisition will have beyond possibly raising Cochlear’s brand awareness in audiology practices or to strengthen the company’s relationship with doctors. Nonetheless, with a purchase price of US$78m, it’s a relatively small acquisition and shouldn’t do too much damage if things don’t pan out.
Management expects net profit of $210–225m in the 2017 financial year, an increase of 10–20%. That puts the stock on a forward price-earnings ratio of around 38. It's no bargain, but with economies of scale, a dominant market position, excellent margins and a strong R&D pipeline, we continue to recommend you HOLD.