Is Cochlear Too Expensive?

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

Cochlear's services and upgrade business is expected to feature over the rest of the year, until the company reasserts its leadership in product innovation and new implant growth gets back on track.

-Pressure on Cochlear to develop its own MRI-compatible implant
-Brokers suggests risks are not properly reflected in the share price
-Flat implant unit sales expected to materialise again in the second half
 

By Eva Brocklehurst

Cochlear Ltd ((COH)) has hit a speed bump, sustaining market share losses in the US and confronting funding caps and reimbursement issues in Western Europe. While implant unit growth stalled in developed markets in the first half, the services business was robust and featured demand for N7 processor upgrades.

Competitor, Advanced Bionics, has surprised the market by taking market share in new implants with its MRI-compatible offering. The dramatic slowdown in Cochlear's unit sales in the last months of 2018, signals to brokers that market share will erode until the company can provide an MRI-compatible unit of its own.

Morgan Stanley notes the Advanced Bionics Ultra 3D implant was not launched until September 2018 and, therefore, expects unit growth for Cochlear will deteriorate further as market share losses persist. Still, the broker has seen market share vary on the back of product cycles before, pointing out the company benefited recently from being the first to market smart phone compatible products.

It is not clear whether Cochlear has a competitive solution as yet, which reminds Wilsons that the market leader sometimes gets caught napping. The broker observes the Sycle business has made a slow start but its technological solutions should play a role in standardising and implementing candidate criteria. Wilsons, not one of the eight stockbrokers monitored daily on the FNArena database, downgrades to Hold, with a target of $188.

CLSA points out it may take six months to develop a competitive product and a further six months to obtain approvals. As a result, the broker has reduced implant volume growth forecasts to 3.7% from 6.2%. This is somewhat offset by increased growth expectations for upgrades and accessories. CLSA, also not one of the eight, understands the business is investing for growth but considers the stock expensive. An Underperform rating and $176.65 target are maintained.

Cochlear faces a tough year but Ord Minnett expects the setback will prove temporary, as the company is almost certain to respond with a new offering by early 2020. The broker is confident MRI compatibility will be offered with the next implant as functionality is well-established.

However, such developments cannot be rushed and Ord Minnett suspects the benefits will not be realised until FY21. The broker is reminded of the risk inherent in the business and believes this is not appropriately reflected in the current share price. While earnings growth is likely to be maintained, declining unit sales and uncertainty over the IP legal case could test investor nerves.

Services

Services revenue was up 28%, with a strong uptake of the recently-launched N7 sound processor. The company has indicated this uptake is in line with the previous generation processor.

Morgans expects services will do the heavy lifting for FY19 and, as it is early in the N7 upgrade cycle, strong growth is likely. The broker acknowledges investors will question the company's competitiveness and R&D leadership, and there are risks to the downside as growth in the installed base stagnates.

Outlook

Citi found a lot to like about the results, although downgrades to Neutral from Buy. Specifically, implant sales in emerging markets increased by over 15%. Citi assumes no implant volume growth in the Americas in the second half but expects market share growth will return.

The broker considers the long-term investment thesis positive, as the company has a leading position in a growing market which has high barriers to entry. Still, near-term valuation upside is limited. The company has maintained FY19 net profit guidance of $265-275m and expects to maintain net margins by adapting investment to revenue growth.

Credit Suisse drops its rating a notch as well, to Underperform. The broker believes the next 6-12 months will be challenging and market share losses will be amplified in the second half and into FY20. Flat implant unit sales are expected to materialise again in the second half, as the company cycles a strong comparable period.

Unit sales growth is then forecast to recover to 6% in FY20. In such an environment, the broker believes the stock is overvalued, as Cochlear trades at a 36% premium to its global medical device peers on an enterprise value/EBITDA basis.

Macquarie agrees the valuation is elevated, noting the stock also lacks appeal on a PE/growth basis relative to domestic healthcare stocks. Investment in sales and marketing and R&D should be supportive in the longer term but the current share price implies growth rates ahead of base case forecasts.

The company has increased expenditure on its manufacturing facility in China, to $36m, and this is expected to be completed by the end of FY20. The company has also made an investment in Nyxoah, the medical device business which is developing a hypoglossal nerve stimulation therapy for the treatment of obstructive sleep apnoea.

FNArena's database shows four Hold ratings and four Sell. The consensus target is $168.11, signalling -4.8% downside to the last share price. Targets range from $155 (Ord Minnett) to $190 (Citi).

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