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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-Management review continues
-Bulk billing still seen under pressure
-Lack of clarity on specific weakness
 

By Eva Brocklehurst

Primary Health Care ((PRY)) has cleaned up its balance sheet, signalling a more conservative approach to provisioning. Write downs in FY16, worth around $98m, will address the carrying values of a number of items.

The company expects to meet the lower end of its $110-115m profit guidance on an underlying basis. Further charges totalling $6m will be made and brokers calculate the net result is a downgrade in profit guidance to $104m. While the company suggests its revised guidance is entirely driven by non-operational matters, brokers are not so sure and remain cautious about the company's operating performance.

Citi suspects half the headline downgrade to guidance stems from slower trading conditions, which translates into an effective 5-6% downgrade to underlying profit. Given the government has been returned after the election with the slimmest of majorities the broker envisages little likelihood of a reduction to pathology funding in the short term, while industry volumes appear firm.

The presence of Jangho on the company's share register supports the stock, given the elevated risk of a takeover. This is countered, in the broker's view, by the high level of flux in the business, as a new management team with limited experience in health care continues to review and make changes.

Macquarie also believes the relatively minor reaction to the earnings announcement indicates the stock continues to trade largely on takeover speculation rather than fundamentals. Jangho's stake is around 16%.

The re-vamped balance sheet is welcome but Morgans notes FY16 has been marked down for a third time in 12 months while trading conditions have been in line. The broker suspects that while the divestment of a number of non-core assets will help to reduce the cost base, the fact that bulk billing is under pressure cannot be denied.

Funding changes remain on the horizon and there is uncertainty regarding the impact of profit improvements already underway or planned, such as increased private billing, selective co-payments, new medical centres and cost savings.

Morgans revises FY16 estimates down 8% but raises its price target by 20% to roll forward and increase depressed valuation multiples. This reflects progress on the company's plans amid uncertainty regarding how strategic initiatives will actually play out.

UBS suggests the update represents a modest 3.6% underperformance against its estimates and the net effect of the trading update is not material to valuation. On the issue of the implementation of Medicare reform, the broker suspects the election outcome could bring about a weakening of the government's resolve, citing media speculation the coalition government will consider undoing the freeze on the Medicare rebate and overturn the cuts to bulk billing.

The broker's forecasts incorporate the unwinding of the bulk billing incentive reductions via top-up deals for pathology and diagnostic imaging, but for FY17 only. Further changes could be of benefit in FY18, as could any change in the stance on the freeze to the Medicare rebate indexation.

Addressing legacy issues on the balance sheet is a good sign but Morgan Stanley expects more might be needed before the company arrives at a structure which can support its future strategy and improve capital recycling. While an improvement in cash flow and returns is expected, the broker considers FY16 in the near term looks a little light versus expectations, with a lack of clarity regarding specific areas of weakness.

The issues at the start of 2016 are becoming a little clearer with the results of the election, with the possibility the funding cuts in the government's MYEFO announcement may not happen, although these are incorporated into the broker's forecasts. Meanwhile, the company's issues with GP remuneration still need to be cycled through and the impact on the financials remains to be seen.

The broker maintains the story is about creating confidence in management's strategies and more certainty is required as to whether Primary Health Care has reached an inflection point on earnings. Until this is achieved, Morgan Stanley remains on the sidelines.

There is one Buy rating on FNArena's database - UBS. Besides this, there are seven Hold ratings. The consensus target is $3.47, suggesting 8.2% downside to the last share price. Targets range from $2.80 (Macquarie) to $4.11 (UBS).
 

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-Positive impact of direct US distribution
-Opportunity in high flow oxygen therapy
-Gains market share in masks
-Loses share in flow generators
 

By Eva Brocklehurst

Fisher & Paykel Healthcare ((FPH)) extended its track record of beating earnings guidance for another year, delivering FY16 net profit ahead of most broker forecasts and proffering FY17 guidance that appears conservative.

Deutsche Bank envisages upside risks to guidance at current FX rates. At spot FX rates the company is expected to enjoy a NZ$9m currency tailwind to earnings. The broker is attracted to a decade-long growth story in and considers FY17 profit guidance of NZ$165-170m is conservative. Moreover, the company has a consistent record of upgrading guidance that is provided in May three months later.

FY16 is the fourth year in a row the company has delivered strong double digit growth in profit as it continues to gain traction in its Obstructive Sleep Apnea (OSA) masks and new Respiratory & Acute Care (RAC) applications. Deutsche Bank believes the result is even better than it appears at first glance, given disruption was expected from a move to directly distributing RAC products in the US.

Citi also notes industry sources had indicated the internalisation of US sales, previously distributed by CareFusion, would provide an opportunity for competitors, as hospitals seek one-stop shops for respiratory care. Yet, the broker observes no material impact, and suspects this is due to F&P Healthcare's large and dominant market share in humidification circuits.

Earnings were up 24% in FY16, slightly below Citi's expectations. The RAC division grew revenue by 16%, with consumables from new applications growing 30%. Revenue was helped by higher US pricing, achieved through internalisation. Gross margins expanded 280 basis points on a constant currency basis, which Credit Suisse attributes to a shift in mix to a higher margin product and the ongoing skew in production to the Mexico facility.

The broker calculates new applications revenue within the RAC segment increased 23% in the second half, after adjusting for the positive impact of the transition to a direct distribution model. The broker's discussions with management have highlighted the positive leverage potential that exists across RAC therapies.

All humidified therapy has the potential to be interlinked. In theory, therefore, the growth achieved in one category should act as a positive lever for growth in another. Credit Suisse also believes this could act as a natural barrier to increased competition.

Brokers observe there is considerable opportunity for high-flow nasal oxygen use. These new applications now account for 50% of RAC consumables revenue. Citi believes high flow oxygen therapy is in a sweet spot, as it provides for lower nursing and cost burden than standard oxygen therapy and, hence, continued strong growth is likely. Both UBS and Credit Suisse also note this is main driver of underlying RAC revenue growth.

Citi likes the annuity style of much of the RAC consumables revenue and believes, despite stiff trading multiples, the stock is attractive based on the high quality RAC division. The broker also observes wound humidification offers a further avenue for growth but requires significant investment, given a presence in surgical suites would be required.

Meanwhile, OSA masks continue to gain market share and Citi highlights the prospective launch of a nasal pillow mask in FY17 to round out the product portfolio. One area where the broker observes the company losing market share is in OSA flow generators and wonders whether F&P Healthcare can be a viable player in the OSA market if it only sells OSA marks, which the broker estimates contribute 80% of OSA division revenue.

This may not matter in the short term but there could be consequences for the longer term, Citi suspects, if bundling leads to disintermediation in the US DME channel, or if either ResMed ((RMD)) or Philips implement a technological lock on their flow generators.

The company expects profits to double in the next 5-6 years and Macquarie is comfortable with this forecast for the medium term. The broker explains the stock's strong multiple by the increasing proportion of revenue from consumables, increasing gross margin and strong market position.

While Macquarie acknowledges it is becoming more difficult to justify the valuation with a discounted cash flow model, the company does have a history of positive surprises. The main risk to the investment thesis, the broker contends, is the NZ currency.

While the company continues to show good execution on a strategy which has transformed the business, with the share price up 63% over the past year, UBS believes growth is more than captured in the price and this leaves little room for execution risk.

This is considered particularly the case against a backdrop of a maturing OSA product and NZ dollar volatility. Hence, the broker has a Sell rating, the lone one on the FNArena database. Otherwise, there are three Buy ratings and one Hold (Credit Suisse).
 

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-Substantial rent savings
-Neutralises bulk billing cuts
-Concerns over GP reaction
 

By Eva Brocklehurst

The Commonwealth government and Pathology Australia have reached an agreement, whereby rent reforms for Approved Collection Centres (ACCs) will be introduced to counter the cuts outlined to bulk billing incentives in the Mid Year Economic and Fiscal Outlook (MYEFO).

The measures could support pathology earnings by up to $50-60m, Macquarie maintains, if they are successful at reducing collection centre rents. The broker estimates that the average rent for a collection centre could fall to $12,000 from $70,000 today. With Primary Health Care ((PRY)) and Sonic Healthcare ((SHL)) having around 2,000 centres each, this amounts to a substantial saving.

The government will introduce provisions to clarify the meaning of market value and link this with relative commercial rents. Information required to register ACCs will be expanded to allow for assessment by the Department of Health as to whether an application is compliant. No mention of an appropriate rent was made but Macquarie notes that Pathology Australia has been lobbying for a 20% limit above the local per-square metre rate.

The removal of bulk billing incentives will commence at the date that the changes to the regulatory framework take effect. The government has also promised not to change the pathology services table for the next three years without consultation with the sector. The legislation is expected to be implemented from January 1, 2017.

Cuts will be effective in the second half of FY17 while the rent benefit will accrue over 12 months as licence renewals are staggered through the year. Macquarie observes it will be FY18 before earnings tailwinds are experienced and FY19 before the full benefit flows through.

So, what does the end result mean for providers? Credit Suisse previously included a 50% impact from the bulk billing cuts in the government's MYEFO, with the introduction of patient co-payments, and now introduces reduced rents on centres. This results in a neutralising of the removal of incentives.

There are some assumptions that need to be made, the broker acknowledges, such as general practitioner (GP) referral rates for pathology being unchanged despite reduced rental income. The broker upgrades Sonic Healthcare on the back of the news, to Neutral from Underperform in keeping with its rating on Primary Health Care.

Macquarie retains Neutral ratings on both Sonic and Primary, highlighting the uncertainties that exist. Obstacles to achieving the desired outcome include the government failing to win the upcoming election, rent reductions being offset in other ways to compensate GPs for directing pathology to a specific provider, and whether other loopholes to the legislation are found.

On the back of the agreement, Citi reinstates the forecasts for both stocks that were in place prior to the MYEFO cuts were announced. The broker maintains a Neutral rating for Primary and a Sell rating for Sonic. Morgan Stanley on the other hand believes there is increased upside risk for the stocks now, with the ability to charge increased co-payments potentially at risk but with greater benefit from the win on rents.

The broker highlights the lack of reaction from general practitioners so far, given the non-indexation of their funding is extended to FY20. A reduction in collection centre rents may further undermine the profitability of their industry.

Addressing ambiguities to better define fair market value for collection centre rent has potential to reduce the overspending on rents, which UBS estimates is more than $150m per annum. The broker highlights this as a vexed issue for some decades, with no legislation seemingly effective and operators finding ways around it. In return the industry ha agreed not to expand co-payments.

If the government is re-elected on July 2 it will call a moratorium on any opening of new collection centres. UBS suggests this has potential to create a race to open new centres in the next six weeks – if labs are prepared to bet on a Coalition win. The broker also notes the broader potential impact in that owner GPs stand to lose income.

Regardless, the broker considers the election of either major party will neutralise the impact of cuts to Sonic Healthcare and Primary Health Care, given that Labor rejects cuts to the bulk billing incentives all together. What remains is a timing issue around rent reviews and any issues regarding effectiveness of the enforcement of regulations. UBS notes there were no comments on incentive cuts to diagnostic imaging and assumes the policy is unchanged.

Sonic Healthcare has four Buy, three Hold and one Sell (Citi) rating on FNArena's database. The consensus target is $20.23, suggesting 7.0% downside to the last share price. Primary Health Care has one Buy (UBS) and seven Hold ratings. Consensus target is $3.46, suggesting 4.3% downside to the last share price.
 

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