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Morningstar | Cochlear Delivers Efficiency Gains and Amplifies Gross Margin; Raising FVE. See Updated Analyst Note from 14 Aug 2018

Wide-moat Cochlear delivered another sound full-year result that met our bottom-line expectations. Reported net profit after tax of AUD 245.8 million was in the middle range of guidance, and just short of our forecast of AUD 250 million. Nonetheless, we were impressed by the improvements in cost of goods, reflecting manufacturing efficiencies, lower warranty cost, and lower repair expenses resulting from the centralisation of repairs globally in Malaysia. This culminated in a gross margin for the year of 73%, up 2% compared with the prior period. We now think these efficiencies are sustainable. As such, we have increased our fair value estimate for Cochlear by 9% to AUD 173 from AUD 159 per share after increasing our medium-term gross margin assumption to 73%, from 71% previously. We forecast this metric trending towards 73.5% over five years, given assumed additional efficiency gains.

We also remain positive on the growth prospects for Cochlear, given the adult opportunity in developed markets and paediatric market in emerging markets, and we remain comfortable with an 11% five-year CAGR for group revenue. However, with forward P/E of around 40 times, we think the market’s growth expectations are overly aggressive, suggesting annual gains of about 13.5% at current levels, and we consider shares in Cochlear to be overvalued.

Cochlear implant sales revenue from the Americas (U.S., Canada, and Latin America), representing 48% of group revenue, was a highlight of the result, increasing 11% to AUD 648.5 million. This was largely driven by 15% growth in cochlear implant units, with strong uptake among the 65-plus senior market in the United States. We remain positive on this segment in developed markets, given the ageing demographics,; the growing body of evidence linking hearing loss and medical conditions associated with ageing, such as dementia; and relatively low penetration rates to date, estimated at around 3%. Further, we think there is a paradigm shift under way in the treatment of hearing loss in the elderly among clinicians, bringing the use of cochlear implants into the mainstream.

As outlined in our note on June 20, 2018, and in our special report “Cochlear Turns Up the Volume as Competitors Quietly Expand,” published Dec. 20, 2017, we expect Cochlear’s installed-recipient pool to grow at an average of 11% per year over the long term, with the global cochlear implant recipient pool growing 12% per year from an estimated 567,000 in fiscal 2018 to approximately 890,000 units by 2022, and Cochlear's market share declining to 56% by 2022 from around 60% currently. We also assume an average cochlear implant system price of around AUD 25,000, together with price inflation of around 2% per year.
Service divisional revenue, comprising the latest Nucleus 7 sound processor release in second-quarter 2018, grew strongly at 15% year on year in constant-currency terms and included full-year contribution from Sycle, the audiology practice management software business acquired in May 2017. We expect momentum in this division to remain buoyant, given the Nucleus 7 release, in the context of an average product life cycle of five years and direct-to-consumer engagement strategies, such as Cochlear Link, expediting upgrades to the installed-recipient base. As such, we forecast revenue five-year CAGR of around 10%, with divisional revenue representing 25% of group revenue in 2023.

Sales generated by Cochlear’s acoustic business, its Baha product range, declined 1% year on year after cycling against a strong previous corresponding period that saw sales increase by 26% in constant-currency terms. Nonetheless, we see the global ramp-up of the Baha SoundArc as expanding the addressable paediatric market and as a positive for growth in the division. The device is a nonsurgical wearable option extending Cochlear’s bone conduction implant system, catering to young children with mixed hearing loss not already fitted with implants.

From a balance sheet perspective, Cochlear is in a strong financial position. Net debt/EBITDA of 0.23 times as at year-end fiscal 2018, following debt reduction of AUD 43 million, coupled with strong cash flows from operation, gives us confidence in Cochlear's ability to maintain its 70% dividend payout ratio with ample capital available to fund construction of a manufacturing plant in China, which is now under way.