Australia | Sep 21 2011
– Analysts still unsure over impact of recall
– risks remain to the downside
– Morgan Stanley joins the downgraders
By Greg Peel
It was over a week ago when leading global hearing implant manufacturer Cochlear ((COH)) announced it had recalled its most recent product, the Nucleus 5, due to an unexplained tendency for some devices to turn themselves off. The market's response was swift and severe on the day and then more bad news was to come. Cochlear shares have since fallen around 25%.
It's a bitter blow for this previous stock market darling. If you want to make a biotech executive squirm just quietly say the word “recall”. At least in this case the recall occurred simply because devices weren't working properly rather than any recipient's health being affected. But with the problem not yet obvious to Cochlear technicians, brokers expect it will be many months before the Nucleus 5 can be back on the market. And that leaves plenty of time for the sharks to move in for the kill.
Cochlear has long attracted a premium valuation to market based largely on the fact it has for a long time been the global leader in its field. There are other devices on the market, but Cochlear's competitors have never been able to make the dent in Cochlear's dominant market share they'd like to. And they, too, have had their own problems with device recalls. The Nucleus 5 recall came at a time major competitor Advanced Bionics was still suffering from its own product recall. The return of the AB product was not expected for a couple of months.
Stock analyst response to the Nucleus 5 recall were initially somewhat mixed. Obviously it was a blow and forecasts earnings and target prices were duly chopped as a result, but just how much of a lasting blow would it prove to be? That is the problem. The voluntary recall was more of a reliability issue than a total product failure issue and Cochlear was obviously erring on the side of caution, but the previously unquestioned reputation of the market leader had been damaged.
Irreparably? That remains to be seen. In the shorter term it's all about whether Cochlear's competitors can successfully exploit the market share opportunity granted them and in the longer term it's about whether they can do so permanently. Thus it didn't help Cochlear's cause, and market sentiment, when only days after the recall Advanced Bionics announced its own recall was now over – a couple of months ahead of expectation.
On the initial news of the Cochlear recall, both RBS Australia (Buy) and Credit Suisse (Neutral) questioned whether the company's competitors really had the scale and the capacity to make a significant dent in its superior market share. By contrast, BA-Merrill Lynch and UBS immediately downgraded to Sell, joining Citi which was already citing overvaluation. Merrills noted that the Nucleus 5 represented 44% of global device supply and 65% of Cochlear's earnings and as such the downside potential could be significant. UBS suggested Cochlear's reputation was now damaged.
The Merrills analysts did subsequently note that the early return of the AB product implied the US Federal Drug Administration was not going to scrutinise hearing devices as stringently as had been assumed. This meant Cochlear was possibly being over-cautious for no reason and could possibly get the Nucleus 5 back on the market more expediently, but nevertheless the damage had been done in Merrills' view. Market share losses would likely be greater with the AB product quickly filling the vacuum.
Morgan Stanley does not believe the Nucleus 5 will be back quickly, and indeed believes it will be off the market for an “extended” time. The quick return of the AB device means Cochlear's market share losses will be exacerbated, the analysts suggest.
On news of the recall, the analysts did some investigation and found that the last four months showed a sharp acceleration in Nucleus 5 “failures”. What's more, the time to failure from implantation was around 4-7 months, implying more to come. These findings, suggests Morgan Stanley, increase the likely ultimate cost of the recall to Cochlear.
Despite Cochlear's 25% drop in share price to date, Morgan Stanley has elected to drop its target another 17% lower. Initial cuts from the FNArena database brokers took the average target to $57.95 but MS has set $45.17 and will not rule out even further cuts as developments unfold. Unsurprisingly, the broker has downgraded to Underperform.