Is Cochlear losing its edge?

Dig Howitt is the CEO of Cochlear, the hearing implant company which obviously is the global leader in hearing implants. I spoke to Dig a year ago and the share price is now exactly the same as it was then; it fell to $160, it was $211 roughly, $210, fell to $160 and now got back there to where it was. The thing about Cochlear is that it’s expensive still; it’s above 41 times PE based on forecast earnings for next year. The question is why would you buy this stock at such an expensive price and the answer is because you think it’s going to continue to grow at roughly 10 per cent to 12 per cent per annum which is what it’s been doing for the last couple of decades really.

It’s basically a 10 per cent compound growth company; what I focussed on in the interview is a competitive glitch they had last year where they lost market share because they were slow with coming out with an implant that was suitable for an MRI machine and one of their competitors or a couple of their competitors stole a march on them. The question is, and this is really the focus of the interview, the question is is Cochlear Ltd losing its touch competitively, what’s it spending its money on and can it maintain its market share? I’m not sure I’ve got the answer but certainly, we’ve got more information from Dig Howitt about it.

Here is Dig Howitt, the CEO of Cochlear Ltd.

I’d like to start with the competitive situation, there was a lot of coverage after your results, a lot of talk about how you were beaten to the market with an MRI compatible implant. Just take us through what happened there. I gather that Advanced Bionics, which is a subsidiary of Sonova, the Swiss business, came out with a cochlear implant that was okay in the MRI machine, is that right? And that was before you came out with the same thing.

Yes. If we start by going a bit further back in time back in 1997 we released the first Cochlear implant that was approved that had indications for use in MRI machines and that was 1.5 tesla there was a need to bandage the implant but people with the implant could go in MRI machines. In 1997 we headed down this path of saying there’s a reason that people might want an MRI once they have had a cochlear implant, we should cater for that. In 2015 another of our competitors, Medel, launched an implant that was compatible both with 1.5 and 3 tesla MRI machines so that sort of lifted the bar a bit, so we’ve seen that on the market in 2015. Then Advanced Bionics launched a product in early financial 2018 and that’s when we started to lose a little bit of market share in a couple of important markets around that feature.

Then in May this year we launched an implant that also was compatible or indicated for use in a 3 tesla MRI machine. We certainly had a competitive gap there for a little while but we have now closed that which is very important from a competitive perspective, it enables us to focus on hearing performance and hearing outcomes which are the reason people get a Cochlear implant in the first place.

I’ve got no idea what a tesla is apart from a car, but why is it that you took four years to come out with a 3 tesla implant?

Because first of all implant development does take some time for sure but also we’ve got a long list of opportunities to improve outcomes and performance of our system and so in the decisions we make on our R&D we’re trading off a number of different priorities and so we focussed on getting what we thought were key products to market between 2015 and 2018 and if you look at that period of time I’d say we mostly made the right decisions, that our market share increased from 2014 right through to 2018 and then we started to lose a little bit of market share in the last year.

What were the decisions you were making?

The key products we launched in that time there was three products that were very important. First was Kanso which is an off the year sound processor so it’s a very good hearing outcome but also quite discrete so less visible, cosmetics for a cochlear implant are important. We launched the CI532 implant which is a new electrode, a slim electrode that gets very close to the hearing nerve and we know that that is important to improve hearing outcomes and we are just now just about to launch or get some data from clinical studies that show how important that closeness to the hearing nerve is. We launched Nucleus 7 and Nucleus 7 was the first sound processor that was compatible with iPhones, so you can stream directly from an iPhone to the sound processor and implant, so whether that’s music, phone calls or podcasts. That continues to prove a very popular product.

We’ve got to make these decisions in R&D, we’ve got some very important things we want to do. We’ve had some competitive issues we’ve got to tackle and we make decisions on what’s the order of features and launches. Looking back I’m quite comfortable with the decisions we made along that path that has put us in the position we are now which is a very strong position going into the new financial year.

You’re saying that you didn’t make a mistake?

I am saying that, I think we made some calls on the priorities and the order in which we’d launch things. If we went back and did those things again I think we’d make the same decisions on priorities because of how effective that Kanso, Nucleus 7 and 532 products are all about improving hearing performance and the market share that we gained over that time we lost a little bit of it last year but we gained a lot more over the previous year than we lost and we’re already starting to regain some of that share now that we do have a 3 tesla compatible implant.

I suppose the issue that people will look at with you is that you’re the clear market leader globally, I think 60 per cent of the market, and you’re up against some pretty big spending pretty large competitors and I suppose the observation would be that your market share can only go down from here. It’s going to be hard to get it up, that’s for sure.

I think so. If you look around you see there aren’t too many companies that sustain the level of market share we have over a long period and we have done that for now heading for 40 years and we have a very significant market share. Obviously, our goal is to retain that level. We spend 12 per cent of our revenue each year, actually 13 per cent last year, on research and development, over $180 million AUD. We deliberately do that because we think it is very important for retaining our competitive position and improving hearing outcomes for our customers or potential customers. We think scale is important in R&D so if we make the right decisions and execute well we would see that we can continue to hold the significant market share that we have albeit we are in a very competitive market as are most companies these days. We don’t take anything for granted.

You’re benchmarking your R&D spend at 180 million and 12 per cent of revenue or 13 per cent of revenue, are you benchmarking that against your competitors? What are they spending, I haven’t had a chance to look at that?

As best we can, it’s hard to see. Medel is a privately held company and we’ve very sure we spend more in absolute dollars but it’s hard to know exactly how much they spend. Advanced Bionics being part of Sonova Group we can get some visibility but they would also leverage off Sonova’s R&D in hearing aids but again given how much bigger we are than both of those two companies when we look at our percentage of revenue and we look at the product portfolio that we launch we’re very confident we’re not only spending more but we’re spending it effectively. It’s hard to get exact numbers but we get a pretty good sense.

Fair enough, do you feel like you’re at a disadvantage not being a part of a hearing aid business or is that an advantage?

We just think it’s an advantage because we’re very focussed on implants and implants are by their nature difficult to design, difficult to make because of the rightly high requirements for safety and performance so I think that focus is good for us. We have over the last several years been working with GN ReSound, and GN ReSound are an important hearing aid company, one of the very innovative hearing aid companies. Last year we announced a strengthened collaboration with them where we will collaborate to jointly develop some product source and components for products and that gives us access to some of the hearing aid technology and gives them access to some of our knowledge and insights so that we are able to develop products that incorporate hearing aid technology as well as our IP and knowledge for 40 years of Cochlear implants.

It’s probably fair to say, isn’t it, that your growth is not going to come from market share growth but rather penetration of implants into the hearing challenged market place, that’s a fair comment isn’t it?

Definitely, yes. To grow we’ve got to be in a market that can grow, that is growing, and a significant bit of our strategy and a big bit of our investment is trying to stimulate growth because we know we’ve got very effective products and there’s an enormous opportunity but people are not easily connected with that opportunity. Very few people know what a cochlear implant is, even people with significant hearing loss, and there is not a clinical path from hearing aids to cochlear implants. Virtually everyone knows what a hearing aid is, people with significant hearing loss most of them are now getting hearing aids, but there isn’t a clear path for them once their hearing deteriorates to a point at which hearing aids are not very helpful to go from there onto a cochlear implant so we’ve got to build that clinical path to enable the penetration and to enable the growth of the industry.

I find that a bit surprising. As you say, you’ve been at it for 40 years and there’s a few others in the game, it’s kind of surprising that there’s no clinical path from hearing aids to implants.

Yeah, it is and it isn’t. For a lot of that 40 years we’ve been focussed on children and building a clinical path for children born with severe to profound hearing loss and that’s now done in developed markets, there’s a very clear path for new born hearing screening and referral. That’s why we think the penetration in developed markets for children with a significant hearing loss is around 60 per cent whereas for adults and seniors it’s about 3 per cent. It’s really I think only in the last five years of the performance of cochlear implants has improved to the extent that they’re now a very good option for people who still have some hearing. If you go back in time cochlear implants were for people with profound hearing loss, people with no hearing, they would get a cochlear implant. People with some hearing, no matter how small, would get a hearing aid.

We have just run a study with Nucleus 7 and the 532 electrode where we had 100 people and we measured their hearing performance, their quality of life and their satisfaction with their hearing performance with two high powered hearing aids and then got a cochlear implant and a high powered hearing aid. After some time of adjusting to the implant we re-measured their hearing performance, their quality of life and their satisfaction with their hearing performance and we saw very significant improvements in all three of those areas. These were people that could hear with hearing aids but they were hearing about three words out of ten, so they’re not what we’d typically call deaf but they certainly don’t have very good hearing. With a cochlear implant they’re hearing nearly all of the words out of ten right, I think it was about seven words out of ten right on average. Their satisfaction with their overall hearing went from 9 per cent with the hearing aids to 95 per cent with cochlear implant and hearing aid.

That’s the sort of data that hasn’t been produced before that says who is it, what are the criteria for someone who will do better with a cochlear implant than with a hearing aid and how much better will they do? It’s only been the last five years the technology has been good enough I think to really give that uplift in performance and it’s only just now that we have done a study that demonstrates how effective cochlear implants are for adults with certain levels of hearing loss.

Is the business of building what you call a clinical path from hearing aids to implants, is that just about getting that information, that data, out there and getting doctors to see it?

That’s a big part of it, I think the awareness amongst professionals who deal with hearing care of how effective cochlear implants are these days and having good clinical evidence to back that is a very big part of building that path. Just doing the study is a good step but we have got to make that study available, be able to educate people on how was the study done, what does that data show. With all these things one study is usually not enough, you need corroborating studies that show similar things done by other people for people to really see it and believe it. It’s all a step on the path, we’re taking a very long term view of what we need to do and trying to invest as much as we can while still maintaining our profit margin, paying dividends, in building this clinical path. We know it’s a five to ten year journey we’re on, not a one to two year journey.

Last time I spoke to you a year ago the penetration of implants I think you said was 3 per cent. What is it now and what sort of growth of penetration are you seeing?

I am sure that we have gone backwards in the last year. It’s probably 3 per cent or maybe a little bit less and that’s because people are living longer but still losing their hearing at the same rate so each year there are more people who pass the threshold at which they’d be good candidates for cochlear implant that get a cochlear implant. I reckon we’ve gone backwards in the last year on penetration.

How relevant is the penetration number then in terms of determining what the future growth potential for the business is?

Its relevance is to show the size of the opportunity and that’s the 3 per cent. Whether it’s 3 or 2.9 or 3.1 or 7.5 or 10, we’d hope, isn’t particularly relevant but what it does show and combined with the study we’ve just done shows that there really is a very big opportunity. There are hundreds of thousands of people with severe to profound hearing loss in the developed world but only a very small number of those people are getting cochlear implants but the evidence we have just generated shows that those that do within the right indications get much better hearing outcomes than they do with high powered hearing aids.

What sort of penetration do you think is possible, when you talk about a five to ten year journey what’s the journey to exactly?

We haven’t talked publicly about what’s a penetration number that we’d like to get to but we do think that we want to grow consistently over the long run. What we have said is that we have seen in a couple of key countries growth in over 65s of over 20 per cent over the last few years in the uptake of cochlear implants. We see the market is growing, we see the opportunities there, we’re investing to work out how to build this clinical path but we haven’t put a hard set of numbers pout there that say we’re going to get to this penetration and that means this rate of growth for us, because of all of that would be just quite speculative and I think not particularly helpful in terms of insight into Cochlear as a company from an investment perspective.

Yeah right, fair enough. I suppose the purpose of talking about this obviously is that when I spoke to you last year the share price was 210 or 213 dollars I think roughly, currently it’s 210 to 213 dollars. But it’s still on a PE of above 40 times. To justify an investment at that sort of multiple it requires pretty fancy growth rates in the future. I suppose I’m interested in why should someone buy Cochlear at 210 and 40 times PE.

That’s obviously a decision for investor and what we do is we explain our strategy and our approach, we don’t provide recommendations. What we’re saying is that there is a very significant opportunity in adults and seniors in developed market, we’ve got a big opportunity in children in the emerging markets that we can see decades of growth in front of us and so we don’t put a number on the rate of growth, people can assume that, they can look back at the rate we’ve grown over the last few years but the point being is we have, if we get things right, a very long growth trajectory in front of us. That obviously has an impact on how people might value the company, at what point do you start to fade the growth, we say a very long time in the future.

The growth rate you have been achieving is 9 per cent or 10 per cent.

Yeah, we’ve been around 9 per cent or 10 per cent for the last few years.

And that’s what you’re forecasting for the coming year.

Yeah, guidance is 9 per cent to 13 per cent for this financial year. We obviously grew more slowly last year with some market share losses but I’m pretty confident, as I talked about earlier, that we have overcome specific issues of last year and back to growing at a good rate again.

Very good to talk to you, Dig, I appreciate the time. Thanks.

No problem, Alan, always good to talk.

That was Dig Howitt, the CEO of Cochlear Ltd.