Australia | Dec 15 2011
By Andrew Nelson
Analysts at Macquarie took a little break from covering Cochlear ((COH)). They paused just long enough to do a full review of the company, of the cochlear implant (CI) marketplace and they also surveyed 389 US-based Audiologists. Profit forecasts dropped, the price target fell, but the Buy call and the rationale behind it remain the same.
The big question must be: what did Macquarie learn? In a nutshell, they learned that despite an embarrassing product recall, despite supply constraints and despite the ongoing economic weakness in the US and Europe, people will still go deaf and most of them don’t even know about, or aren’t using CI devices and that Cochlear is still the world leader in that technology.
Cochlear sells its products in more than 100 countries and with a 60% market share, it is the global leader in implantable hearing devices. As you can imagine, this is a great position to be in, so why would Macquarie have to completely reassess its view on such a seemingly straight forward story?
The answer is simple: Cochlear has taken a beating over recent months due to the recall of its Nucleus 5 product, announced back in September. In fact, the share price has shed 25% over the past three months. The broker notes management moved fast to fund the recall, putting aside up to $150 at the AGM in October. Macquarie thinks the amount will be more than sufficient to cover the costs.
But the problem is far from just being the cost of what in the CI industry was a very, very big recall. The broker estimates that 1500 units are going to have to be removed from people’s skulls and another 2800 units have been pulled from shelves. However, the bigger problems are an inventory shortfall across the entire market and thus the threat of market share loss from insufficient inventory and from the reputational damage that was caused by the recall.
Macquarie feels, however, that Cochlear has, is and will recover from both of these issues and in fairly short order.
Looking at the supply constraint, or inventory issue, Macquarie notes the company moved quickly to ramp up production, tripling output in just three months. The company has also been able to push back implants, given most patients moving from an initial implant to a Nucleus 5 implant will want to be sticking with the same brand. The company has also moved to on-demand supply, which the broker notes has been working out well. All up, Macquarie sees all of 2012 demand being met.
The big thing helping Cochlear fill the near term shortfall is its Freedom product, which does pretty much the same thing as Nucleus 5. The product is still very popular. So much so that Macquarie thinks it's really not important when the Nucleus 5 gets back on the shelf, as the Freedom is still better and more popular than what competitors are offering.
The reputational damage is a little stickier, but again, the broker is little concerned. Peers have had the same sort of issues, with many doctors surveyed saying that while the Cochlear recall is larger than any before, it doesn’t raise the same sort of concerns. In fact, the broker thinks the recall may have a counterintuitive effect, pushing doctors into a flight to quality, a metric which Cochlear still leads.
In fact, 93% of doctors surveyed seem to feel that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.
Still, with fewer Cochlear units on the shelf, the broker admits the recall will result in minor market share increases for some of Cochlear’s peers. And while some of these practitioners will come back once supply is restored, there is a chance that some will be lost. Again, the broker thinks this will prove to be only a short to medium term issue, with Macquarie thinking that only 7% of market share will be shed in 2011.
And with Macquarie expecting the CI market to continue growing at 12% a year, and also expecting Cochlear to remain the market leader, the earnings potential for Cochlear remain solid. That said, margins, once the company’s strong suit, will take time to recover to their old growth trajectory, notes the broker. In constant currency terms, gross margin growth has run at around 17% per year over the past 10 years.
Given the N5 recall and the uncertainty as to when the company will return to automated assembly, the broker has pencilled in flat gross margins going forward on a constant currency basis. This has caused the broker to cut its FY12-15 net profit expectations by 40%, 15% and 24% respectively. Macquarie admits it’s probably being a bit too conservative and expects that much of these cuts will be peeled back once Cochlear gets back in to the groove.
That takes us to the maintained Buy call. With Macquarie of the opinion that Cochlear’s current woes will soon be history, the broker simply thinks that the current price is just too good to pass up.
Investors should note Macquarie's new price target is the highest of the eight stockbrokers monitored daily by FNArena. Six out of the remaining seven stockbrokers have a more cautious stance (Neutral) or are negative on the shares with most price targets set well below the current share price. RBS is the only one who shares Macquarie's positive view.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
