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BUY, SELL or HOLD (ASX:COH)

Cochlear Limited (COH) is a manufacturer and distributor of cochlear implantable devices for hearing impaired. The implant systems comprise of an implant, which is inserted during surgery and an external sound processor. Cochlear has operations in more than 20 countries distributing its products in over 100 countries in the America, Asia Pacific, Europe, Middle East and Africa regions. It offers three main products namely: Cochlear implants, Baha bone conduction implants and Cochlear Wireless Accessories.

  • Cochlear implants: Cochlear implants are a solution for people with moderate to profound hearing loss. They provide a solution through their Nucleus 6 system and Aqua+.
  • Baha bone conduction implants: Baha bone conduction implants are a solution for the people with conductive hearing loss, mixed hearing loss and single-sided deafness. The Baha System uses the body’s natural ability to conduct sound through bone conduction, and has the potential to make an immediate impact on how well patients hear and communicate.
  • Cochlear Wireless Accessories: Cochlear Wireless Accessories help to explore audio unbound by the constraints of wires and bulky components from less advanced systems. They have range of accessories including the Cochlear WIRELESS Mini Microphone 2, Cochlear Wireless Mini Microphone 2+, Cochlear Wireless Phone Clip and Cochlear Wireless TV Streamer.

INVESTMENT CASE

Positive

  • Market opportunity – Over 8% of the global population – 360 million people (328 million adults and 32 million children) – have disabling hearing loss. Nearly 1 in 3 people over the age of 65 are affected by hearing loss. COH estimates there is less than 5% market penetration, so the scope for increased market growth is significant.
  • Global leader with dominant market position and market leading products.
  • Competitive advantage due to technical innovation and reliability and strong IP position. Medical specialists tend to show strong product loyalty.
  • Management has a strong reputation for developing the product pipeline and leveraging its strong market position by diversifying into the partially deaf market.
  • COH is continually investing in market growth initiatives – new products such as Slim Modiolar electrode and Kanso sound processor as well as sales force expansion.
  • Research & Development – In 1H17, COH invested $72.2m or 12% of sales revenue, into R&D, with a pipeline of new products expected to be launched over the coming years.

Negative

  • Innovation – Technology is changing rapidly and COH must constantly invest to be at the forefront of innovation.
  • Competition – Strongly related to the risk above, a competitor could introduce a better product or new service. There is also a risk that a cheaper “no bells and whistles” type of competitor gains market share in emerging market economies with tight budgets.
  • Technology risk – COH voluntarily recalled the Nucleus 5 implant in 2011 after adverse results (in less than 1% of products issued). While negative for the brand, sentiment and the share price, the conservative decision did manage to preserve a certain amount of goodwill.
  • Currency risk – Around 43% of sales are in the Americas and Europe, the Middle East & Africa is 40% and Asia Pacific is only around 17%, meaning COH’s AUD earnings fall when the AUD rises.

RECENT RESULTS

  • Net profit was up 19% to $111m, on the back of revenue being up 4% (or 8% in constant currency).
  • Cochlear implant units were up 10% (to 16,234).The increase was actually 16% when the impact of the Chinese Central Government tender units was excluded and is an excellent performance considering overall market growth of 8-10%.
  • Growth was consistent across both developed and emerging markets. Highlights included continued strong performances from the US and Western Europe and also in emerging markets. There was strong growth in India and China (Other) and solid improvements in Latin America and Central & Eastern Europe.
  • The Acoustics business, representing 14% of revenue, had a strong half with sales growth of 20% in constant currency, driven by the uptake of iPhone enabled Baha 5 Power and SuperPower sound processors across all regions.
  • Cash flow was another highlight – free cash flow was up 50% which enabled an increase in the dividend to 130c (up 18%) and $24m in debt reduction.
  • During the half COH introduced Kanso, its first off-the-ear sound processor and the Nucleus Slim Modiolar electrode, the world’s slimmest electrode, across Europe and the US. It has seen strong uptake of both products, with a notable uptick in unit growth during the second quarter in those markets.
  • Guidance for FY17 was maintained at $210-225m, up 10-20% in FY16.

The result was generally in line with market expectations but shares fell on the day due to slowing sales in China and cautious guidance that units for the full year would be “below FY16 levels”, compared to “in line” previously. You can review the results presentation here.

FUNDAMENTAL VIEW

Cochlear has a very impressive STOCK BOX. High, albeit easing, ROE is combined with a track record of robust earnings growth. While easing over time, it still qualifies as a growth stock based on our criteria.

The yield doesn’t qualify for income-focused investors. Dividends are forecast to grow over time so it does improve marginally, but with the strong historical growth rates achieved by management, reinvestment into new products and add-ons is a better strategic use of funds.

While balance sheet ratios such as gearing are a little on the high side, other measures of financial health, including profitability and cash flow measures, are all exceptional. COH ranks well on financial health overall.

The key concern is value. Shares are trading at a 74.1% premium to intrinsic valuation and an 8.1% premium to the average analyst target price, although as the historical PE demonstrates, they are always expensive, with the strong competitive position and track record of high earnings growth and product innovation demanding a significant premium to the market.

OUR VIEW - Cochlear (COH) is a quality Australian company which has demonstrated exceptional earnings growth and strong share price performance for investors. The thematics are very positive as the addressable market is substantial and COH’s penetration of this market is currently small. The fundamentals are also supportive with high growth and strong financial health. The analysts are not particularly keen - most of them are neutral but there is a definite skew to the downside. The key concern is slowing growth, particularly in China, but with expectations low after the cautious guidance at the 1H results, we think the downside should be limited. While we acknowledge the risks to the earnings from lower Chinese sales and potential “no frills” competition, this is an attractive long term growth story. Our major concern is price and the technical picture suggests waiting for a more attractive entry point. We will continue to monitor COH with a view to add it to the MT Growth Portfolio if shares return (and respect) the medium term uptrend support line, or if the MACD indicator turns up.

TECHNICAL VIEW

After lagging for the most part of 2016, COH shares began to recover late in the year. Following a pause due to disappointment with results, the recovery process has resumed. On the weekly chart, the MACD indicator has been steadily improving although it has stabilized in recent weeks. RSI is toward the oversold levels but not significantly so. Overall, the configuration is mildly positive. The daily chart is similarly mixed - RSI is neutral and the MACD is easy, while shares have also moved away from the upper Bollinger Band, suggesting a bit of short term weakness.

BROKER VIEW

  • Citi has a Neutral recommendation with a target price of 12750c. The analysts express their concern that Cochlear might be legally ordered to pay a considerable amount in its patent dispute with the Al Mann Foundation (AMF) while trading on a lofty PE multiple. They note the US$20m in provisions but think this could be insufficient considering they estimate final damages could be as high as US$500m.
  • UBS has a Sell recommendation with a target price of 12200c. The result was in line with the analyst’s forecasts and saw solid unit sales growth offset by weaker services and upgrade sales. They were not surprised that upgrade sales have now reached the peak of the cycle, although the launch of the new Kanso processor may boost the second half. While they upgraded the target price significantly after the result, the hefty premium means they have maintained the Sell recommendation.
  • Credit Suisse has an Underperform recommendation with a target price of 12100c. The 1H result was in line with the analyst’s estimates, with positives including the 16% underlying unit sales growth and broad-based uptake of the Nucleus Profile implant. They estimate constant currency revenue growth of 8%.
  • Morgan Stanley has an Equal-weight recommendation with a target price of 13800. The analyst notes that service/upgrade revenue was flat in the 1H, as expected, and they have raised FY17 net profit forecasts as a result of more robust unit growth expectations and services performance in the second half. They’ve kept the neutral stance due to potential emerging risks to unit growth.
  • Ord Minnett has a Hold recommendation with a target price of 12500c. First half net profit was in line with the analyst’s estimates and up 19% on the pcp. While it was an easy pcp, they think COH is on track for a strong FY result.
  • Morgans has a Hold recommendation with a target price of 11820c. The result was ahead of the Morgans analyst but they noted the absence of strong gains in services, despite numerous initiatives to improve recipient engagement. They have raised forecasts for FY17 through to FY19 by 2% but don’t think the wide guidance range of 10% to 20% growth is a strong vote of confidence in the company.
 

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