Company Reports

The Australian Competition & Consumer Commission has approved wide-moat Cochlear’s acquisition of Oticon’s cochlear implants business. We had expected this to proceed and maintain our AUD 220 fair value and earnings estimates.

Cochlear is the market leader in cochlear implants with consistent share of roughly 60% across developed markets. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market segment largely penetrated, the company is looking elsewhere for growth with developed-markets adults the next primary focus and emerging-markets children after that.

Cochlear is the market leader in cochlear implants with consistent share of roughly 60% across developed markets. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market segment largely penetrated, the company is looking elsewhere for growth with developed-markets adults the next primary focus and emerging-markets children after that.

Cochlear is the market leader in cochlear implants with consistent share of roughly 60% across developed markets. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market segment largely penetrated, the company is looking elsewhere for growth with developed-markets adults the next primary focus and emerging-markets children after that.

Demant's announcement of the sale of its medical segment to Cochlear ends the firm's unsuccessful decade-plus long excursion into the implants industry and further underscores the challenge of competing with wide-moat Cochlear in this space. We maintain our fair value estimate for the narrow-moat Demant as this segment has long been an investment sinkhole and unlikely to ever become a meaningful contributor.

We keep our AUD 138 fair value for wide-moat Cochlear following a 4% fall in interim 2021 underlying NPAT to AUD 125 million. Sales momentum improved across the half as surgeries recovered faster than we anticipated following COVID-19 shutdowns. We lift our fiscal 2021 underlying NPAT by 10% to AUD 238 million, in the upper half of the AUD 225 million–AUD 245 million guidance range. The implied weaker second half is due to a slowdown in surgeries in early 2021, higher costs to accelerate growth projects, and weaker USD. Despite the quick recovery, our five-year EPS CAGR forecast reduces to 17% from 18% reflecting an updated USD/AUD exchange rate of 0.78 from 0.72. Shares continue to screen as overvalued as we retain our view that the developed market children segment is close to fully saturated.

Cochlear is the market leader in cochlear implants with consistent market share of roughly 60%. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market largely penetrated, the company is looking elsewhere for growth with developed market adults the next primary focus, and emerging market children after that.

Cochlear is the market leader in cochlear implants with consistent market share of approximately 60%. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market largely penetrated, the company is looking elsewhere for growth with developed market adults the next primary focus, and emerging market children after that.

The trading update provided by wide-moat Cochlear was broadly in line with our expectations and we make no changes to our net income forecasts of AUD 92 million for fiscal 2020 and AUD 40 million in fiscal 2021. However, we update our shares on issue to factor in the increased size of the share purchase plan, or SPP, to AUD 220 million from AUD 50 million originally (as outlined in our note on March 25, 2020) and this has the effect of reducing our five-year EPS forecast CAGR to 5.4% from 5.8% prior. However, because the SPP was priced near our unchanged AUD 129 fair value estimate, the increased equity raising has minimal impact on our valuation. Shares screen as overvalued at current levels.

We foreshadowed Cochlear requiring an estimated AUD 600 million to AUD 700 million in funding in our note published on March 17, 2020, and today the company announced an AUD 850 million equity raise, giving rise to an additional 10% of shares on issue. Capital is required to fund the operations through the current COVID-19 crisis, which is causing widespread deferral of cochlear implant surgeries, and the likely USD 268 million patent infringement penalty due. This confluence of events placed a liquidity crunch on Cochlear. In the absence of an equity raise, we forecasted net debt/EBITDA levels rising to over 6 in fiscal 2021, and now expect the company to carry no debt. We make no changes to our recently updated operational outlook for the company, however, the additional shares on issue would reduce our five-year forecast EPS growth to 5.8% from 6.8%. As the AUD 140 new issue price is not significantly different to our AUD 129 fair value estimate, we make no change to our valuation.

Wide-moat Cochlear withdrew fiscal 2020 profit guidance on the back of expected major declines in elective surgeries worldwide as hospital space gets prioritised to deal with COVID-19 patients. Given that cochlear implants are the standard of care for severe hearing impaired children, we expect the delayed surgeries to resume later in the calendar year. We estimate that 60% of implant units sold in fiscal 2019 relate to children across developed and emerging markets. However, in adults, cochlear implant treatment is discretionary and we expect the company may lose 20% of the potential implant opportunities over the next nine months. Once elective surgeries resume, we expect operating theatre capacity and government funding constraints in many markets will limit the pace of the rebound and children will receive priority over adults. The rate at which deferred surgeries resume is a key unknown and currently we assume that around 70% of normalised volumes are achieved in fiscal 2021, with the backlog taking a further two years to catch up. The near-term loss of sales combined with management’s intention to maintain staffing levels leads to reduced profits in fiscal 2020 and 2021. Furthermore, Cochlear’s unsuccessful appeal on a long outstanding patent infringement case sees the company now liable to pay the USD 268 million penalty. We had already included a 50% likelihood of this outcome in our fair value estimate, however, we now expect the near term dividends to be reduced due to cash flow pressure. We reduce our fair value estimate to AUD 129 from AUD 135.

Wide-moat Cochlear’s flat first-half earnings reported proved disappointing. However, this does confirm our thesis that profitable growth is increasingly harder to achieve. While the topline remained buoyant, up 5% in constant currency on the previous corresponding period, or pcp, selling and marketing costs grew well ahead of this, up 9% in constant currency. Selling costs ran at over 30% of revenue, which we expect to persist over the long term as the company invests to drive the top line.

Despite lowering fiscal 2020 net profit guidance between AUD 10 million and AUD 20 million due to the impact of the coronavirus on the China cochlear implant market, we maintain our AUD 135 fair value estimate for wide-moat Cochlear. We expect the implant surgeries to resume once the infection risk associated with hospital visits in China has diffused based on the pattern played out in the SARS epidemic. As at Feb. 11, the timing around containment of the virus and subsequent resumption of surgeries is unclear and we assume the surgeries deferred in fiscal 2020 will occur over the following two years. Based on our estimates of pricing in this market, we reduce our group forecast fiscal 2019 implant units down 6,000 to 30,437 which represents a decline of 10.7% on the previous corresponding period, or pcp. However, we still expect Cochlear to post revenue growth of 6.8% in fiscal 2020 as we assume lower price points on the China units and around 30% of group revenue is earned from the services segment which we expect to remain unaffected.

While wide-moat Cochlear made no changes to fiscal 2020 earnings guidance of 9% to 13% growth at its AGM, the message of slower long-term earnings growth was clear. Management reiterated the company remains in the early phase of getting traction in the adult market for cochlear implants and is investing heavily to build this market. This point was driven home by a downward revision of the EPS targets for the long-term incentive scheme to 7.5% to 12.5% CAGR over four years and from 10% to 20% CAGR over three years. This aligns with our view of 8.1% EPS CAGR over four years and we make no changes to our AUD 135 fair value estimate. Shares screen as overvalued at current levels.

Wide-moat Cochlear delivered fiscal 2019 earnings in line with our expectations and we retain our AUD 135 fair value estimate. Despite disappointing sales growth of 4.6%, with overall cochlear implant units declining 3.3%, the company has a flexible cost base and curbed expenses in order to deliver adjusted ESP growth of 8.3%. The soft sales growth is a reflection of the temporary loss of market share in the U.S., as competitors launched MRI compatible implants ahead of Cochlear, and a decline in the emerging market business. We expect a bounce back in the developed market business, which contributes 80% of revenues, in fiscal 2020 as the newest Cochlear product was launched at the tail end of fiscal 2019.

We lower our forecast revenue growth to 9.2% compounded to fiscal 2023 from 11.4% and consequently our fair value estimate for wide-moat Cochlear to AUD 135 from AUD 180. The growth outlook does not impact our wide moat rating where we see Cochlear retaining its dominant market position and few outside threats to the industry. But Cochlear screens as substantially overvalued at current levels. Our AUD 135 fair value estimate implies a fiscal 2020 free cash flow to enterprise value yield of 3.2% which aligns with other high quality international companies in the 3% to 4% range.

Despite many Australian-listed healthcare stocks we cover having substantial revenue exposure to the U.S., the latest potential regulatory changes in that market pose a low risk to our fair value estimates. The cost of and access to healthcare is an emotive topic among U.S. voters and hence at the forefront of political agendas. Of relevance to the Australian companies that operate in the U.S. is the draft Lower Health Care Costs Act, or LHCCA, which aims to improve transparency in the healthcare sector and reduce prescription drug pricing, as well as President Donald Trump’s recent executive order on transparency and comments on capping drug prices to the lowest developed-country level.

The market didn’t like wide-moat-rated Cochlear’s first-half fiscal 2019 net profit, sending the shares down 8% on the day. We think it was a case of reality not meeting lofty market expectations for the six months just gone. Net profit after tax grew a seemingly impressive 14% to AUD 128 million versus a year ago. However, the result flattered to deceive. It benefited from a lower U.S. tax rate and favourable currency movements. At the pretax line, profit was up a still impressive 10%, but the revenue line was more telling. It grew at 11%, but in constant currency terms, growth was just 6%. Demand for implants was the major source of weakness with volumes up just 5% and revenue flat. Emerging market units grew 15% but developed markets were soft. Cochlear cited increased competition and health budget constraints.

Cochlear has been ordered by the U.S. District Court to pay USD 268 million in damages to the Alfred E. Mann Foundation for Scientific Research and Advanced Bionics due to patent infringement. Cochlear will appeal the judgment with an outcome expected in about two years. Importantly, the damages relate to an expired patent and the ruling should not impact Cochlear’s future business. Cochlear disagrees with the reasons for the damages and will take the case to the U.S. Court of Appeals. Pending the outcome of the proceedings, Cochlear will lodge a USD 335 million insurance bond with the Court.

We have transferred analyst coverage of wide-moat Cochlear and raised our fair value estimate to AUD 180 per share from AUD 173 per share previously. The increase reflects a lower discount rate of 7.5% from 8.9% previously, largely offset by slightly more conservative, though still buoyant expectations, for future growth in revenue and profitability. Our lower discount rate assumption reflects a reappraisal of the nature of Cochlear’s business relative to the rest of our coverage.