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Morningstar | Transfer of Analyst Coverage on Cochlear, Raising FVE to AUD 180 per Share

We have transferred analyst coverage of wide-moat Cochlear and raised our fair value estimate to AUD 180 per share from AUD 173 per share previously. The increase reflects a lower discount rate of 7.5% from 8.9% previously, largely offset by slightly more conservative, though still buoyant expectations, for future growth in revenue and profitability. Our lower discount rate assumption reflects a reappraisal of the nature of Cochlear’s business relative to the rest of our coverage.

Cochlear’s annual general meeting reiterated a consistent strategy and outlook and our fiscal 2019 net profit after tax forecast of AUD 276 million is little changed. It remains at the top of management’s unchanged AUD 265 million to AUD 275 million guidance range. The decline in the AUD/USD exchange rate to about 0.71 is a tailwind relative to Cochlear’s guidance assumption of 0.75. Management expects revenue growth to broadly continue, supported by recent product developments and sales and marketing activity. For developed markets, Cochlear expects similar growth in fiscal 2019, while emerging market growth will be strong but variable depending on the timing of tender activity.

Our use of a lower discount rate reflects a review of revenue cyclicality, operating leverage and financial leverage. The underlying demand for cochlear implants is relatively defensive. Variance in revenue growth is impacted by the roll out of new products, but less so overall economic conditions. The business is relatively high margin, with gross margins almost 75% and EBIT margins exceeding 25%, which means operating leverage is modest. Financial leverage is also minimal with net debt of just AUD 43 million at end June 2018 and forecast net debt/EBITDA of 0.2 in fiscal 2019. All up, we think the underlying stability of demand, Cochlear’s leadership in devices for the severely hearing impaired and modest operating and financial leverage mean a below average cost of equity is appropriate.

The benefit of the lower discount rate is somewhat countered by a modest paring back of our still buoyant revenue growth forecasts. We’ve also assumed a greater proportion of revenue is reinvested in capital expenditure and selling expenses to support growth, in line with management’s strategy. Our forecast average revenue growth rate is now 9.9% compound to midcycle in fiscal 2028 versus 11.0% previously. We also assume relatively stable operating profit margins, forecasting about a 1% improvement to 26.5% in the decade-ended fiscal 2028 versus 30.1% in fiscal 2028 previously. Cochlear’s strategy is to keep a relatively stable profit margin, with unit cost savings from efficiency and growing manufacturing scale to be reinvested to support growth.

We reiterate our wide moat rating for Cochlear, supported by switching costs and intangibles. The firm is focused on the highest-value segment of the market, servicing the severely hearing impaired. With leading market share around 60% of this high-value segment, and approximately 12% of revenue reinvested into research and technology, we expect Cochlear to remain ahead of competitors. Increasingly, Cochlear focuses on the customer experience. The installed base of implant recipients provides an important source of recurring revenue from upgrades and services. Switching costs among people already with implants are very high. Services revenue was 26% of the group total in fiscal 2018 and grew at an impressive 15%. By comparison, revenue from the sale of implants made up 62% of revenue in fiscal 2018 and grew at 8%. Among the implant part of the business, switching costs are also high as medical practitioners typically specialise in one kind of implant.

The firm’s commitment to research and development continues to iterate better solutions for the severely hearing impaired and supports an intangibles moat source. Recent innovations include iPhone connectivity, smaller sound processors and implants, waterproofing and smaller rechargeable batteries. Data logging will provide an important source of information to improve patient experience and future devices.

We see a meaningful unmet need for hearing devices, particularly among those losing their hearing with ageing. Cochlear estimates less than 5% of people who could benefit from a hearing implant are being treated. The strategy to continue to invest to raise the awareness of the problem, both among medical practitioners and the broader community, is sensible and we see a long runway of potential growth for the firm. The key risk is if an alternative method can successfully treat severe hearing impairments. The frontrunner is gene therapy, but viable development of this technology for humans is not yet on the horizon.