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Morningstar | Soft 1H for Cochlear but Maintaining our AUD 180 FVE

The market didn’t like wide-moat-rated Cochlear’s first-half fiscal 2019 net profit, sending the shares down 8% on the day. We think it was a case of reality not meeting lofty market expectations for the six months just gone. Net profit after tax grew a seemingly impressive 14% to AUD 128 million versus a year ago. However, the result flattered to deceive. It benefited from a lower U.S. tax rate and favourable currency movements. At the pretax line, profit was up a still impressive 10%, but the revenue line was more telling. It grew at 11%, but in constant currency terms, growth was just 6%. Demand for implants was the major source of weakness with volumes up just 5% and revenue flat. Emerging market units grew 15% but developed markets were soft. Cochlear cited increased competition and health budget constraints.

Services revenue was a positive, up 21% in constant currency terms. This segment captures demand for upgrades from the existing user base. The high switching cost for users with Cochlear implants is a key underpinning of our wide moat rating. Sound processor upgrades were key to the growth. We like the upgrade story based on the existing pool of implants, but continued growth in the number of implants is important to expand the pool for future upgrades. The smallest segment is acoustics at 13% of total sales revenue. Here, revenue was flat and product innovation will be key to regaining momentum.

Despite the soft half, we maintain our AUD 180 per share fair value estimate. While acknowledging the soft half, Cochlear's revenue growth has varied widely in the past. When sales have flatlined in Cochlear’s history, typically between major launches and innovations, the shares have generally over-reacted. We don’t think that’s the case yet with the shares near our fair value estimate. But further weakness may see market valuations cut and provide investors a rare opportunity to purchase this high-quality stock at a discount.

We still like the long-term drivers for Cochlear. Growing global and emerging market incomes and the ageing population are attractive exposures. It is the market leader and as such has several logical levers to pull to respond to increased competition. While softness in implants may persist in the near term, expansion of the sales effort and a focus on direct to consumer should bear fruit longer term. Cochlear’s strategic response to invest in research and development, or R&D, market access, market education and building clinical evidence are all logical competitive steps. Investments in manufacturing to harness Cochlear’s scale should support the attractive margins while allowing continued investment in sales, marketing and R&D.

Guidance remains for fiscal 2019 NPAT to grow 8% to 12% to AUD 265 to AUD 275 million. Our AUD 271 million full-year forecast is near the middle of this range. This strong apparent profit growth is flattered somewhat by the lower AUD versus the USD and EUR and the lower U.S. tax rate. Cochlear expects the services division to be the key revenue growth driver for fiscal 2019, as it was for the half. Importantly, management says emerging market growth should remain strong. However, Cochlear cautions growth rates can be variable.

For investors focused on the attractive long-term revenue drivers for Cochlear and believing as we do in the firm’s competitive advantages, occasional sluggish revenue growth can provide attractive opportunities to invest. Product innovation will be key to Cochlear regaining sales growth momentum. In the longer term, we’re confident the company’s competitive advantages will support Cochlear’s market-leading position.