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Is Cochlear Overvalued?

Australia | Aug 10 2016

This story features COCHLEAR LIMITED. For more info SHARE ANALYSIS: COH

Cochlear has taken advantage of sales growth to reinvest in development. While brokers approve, they question whether the stock's current premium is justified.

-At weakest point in 4-5 year innovation and product cycle
-Services segment the strongest performing division
-Attention to development could boost sales in adult market


by Eva Brocklehurst

Cochlear ((COH)) has taken advantage of strong sales growth to reinvest in developments and while brokers approve of the move, some maintain that improved operating leverage is required to justify current stock multiples.

Processor upgrade and accessory sales grew strongly in FY16, with the company’s current penetration of the installed base at around 22%. Historically this has reached around 50% at the end of the cycle and management is instituting initiatives to better service its installed base and improve on this figure.

Acoustics sales were up 21% with BAHA up 10%, performing strongly across all regions. FY17 guidance is for profit in the range of $210-225m. Credit Suisse observes, while momentum in developed markets is strong, there is weakness in some of the emerging regions pulling group level unit sales growth back to 4% in the second half.

Meanwhile, the US market has picked up to reveal implants growth of 8-10% and growth in select developing markets such as China private pay and in India is very strong at 40-50%. Nevertheless, Credit Suisse awaits further evidence of a sustained acceleration in unit sales on a global basis, with management recently investing in its sales force to drive consumer engagement in Germany, China, Eastern Europe and Latin America.

UBS believes the slowdown in growth ex China is consistent with an expectation that competitor products and the cycle are emerging as headwinds, with Cochlear at the mid point and weakest phase in its 4-5 year innovation and product cycle. The broker contends the multiples make it difficult to reconcile the stock’s current 70% premium to peers.

UBS suspects investors have misread the recent recovery in growth and hedging gains, believing this is sustainable, without considering the phases of the innovation cycle, and this leaves estimates and valuation overly optimistic. The broker reiterates a Sell rating.

Macquarie acknowledges that once Chinese tenders are eliminated, global implant growth does decline to 7.8% versus 12.4%. Services – upgrades, accessories and patient services – was the strongest performing division, recording 20% growth as the business benefits from the N6 sound processor upgrades.

The broker believes the company’s strategy is be gaining traction, with unit sales growth of 9-10% in mature markets and a step up in the over-65 segment growth. Macquarie concedes the stock is not cheap but notes a return on equity of 47% and a 60% share of a growing and under-penetrated market, retaining an Outperform rating.

The broker contends operating leverage did not materialise as the company ramped up spending on development. Given the strong gains evident from new product launches, and the opportunity that presents if the company can successfully penetrate the large under-developed adult market, the broker lauds the investment in development.

Ord Minnett also observes the company forewent the opportunity to deliver a result above guidance as it brought forward reinvestment in its sales force and F&D, taking advantage of stronger-than-expected sales in FY16. The reinvigorated attention to market development could boost sales in the largely untapped adult market, the broker asserts. Still, Ord Minnett believes the outlook is fully reflected in the current share price.

 The highlight for the broker was the unit growth in the developed market, after a number of years featuring lacklustre sales. A focus on services should support continued growth and the uptake of N6 by the growing eligible patient pool in the US should continue towards 30% in FY17, ensuring sales grow despite the tough comparables.

Services/upgrade revenue is the key swing factor, leaving Morgan Stanley wondering whether this becomes a headwind in the next fiscal year. The broker notes the absolute value of the segment revenue was flat in the second half and may indicate a peak in the current cycle.  Hence, Morgan Stanley models a 5% decline in such revenue in FY17.

Otherwise the broker’s analysis suggests age-related hearing loss will drive growth in the number of cochlear implants in the over  50 category. Despite growth in the number of implant recipients, the analysis also indicates the annual incidence and prevalence of server/profound hearing loss will result in market penetration moving lower. All up, the broker is confident with respect to sustained growth potential within the implant market.

According to a recent survey by the company,  less than 20% of the general population is aware of cochlear implants and less than 50% of audiologists can correctly identify the appropriate characteristics for implant suitability.

Citi maintains Cochlear has a superior suite of products and will launch a new implant with novel electronics to win market share over 12-18 months. The growth in market share is likely to be at a more modest rate and the broker is wary of Advanced Bionics gaining traction in the short term with the launch of a thinner implant.

The broker considers the company’s investment in two ventures, the Earlens device and Saluda Medical, demonstrate a willingness to consider other means to growth in a measured way that should not divert resources from the main implant business.

The Earlens device is effectively a hearing aid with a transducer on the ear drum providing physical separation to behind the ear which should enable a higher gain and wider dynamic range to be achieved. Saluda Medical is developing a closed loop neutron-modulation implantable system for the treatment of neuropathic pain.

FNArena’s database has one Buy rating (Macquarie), five Hold and two Sell for Cochlear. The consensus target is $116.34, suggesting 10.5% downside to the last share price. Targets range from $94.10 (Deutsche Bank, yet to update on the results) and $130.00 (Macquarie).

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