Australia | Feb 06 2013
-Cochlear facing some competition
-Brokers prefer ResMed
-More Sell ratings
-China tender the main positive
By Eva Brocklehurst
Cochlear ((COH)), at the top of the market for hearing implants, is getting some push and shove. A competitor looms, the first serious one in over a decade according to UBS. The company reported flat revenue in the first half, with profit of $77.7 million around 4-5% below broker consensus. Moreover, the road ahead is expected to feature slower established market gains, while the large tender win from China stands out as the main support to earnings growth.
UBS thinks competitor Advanced Bionics' new 40% smaller processor, and thin electrode implant, is arguably better than Cochlear's for the first time in more than a decade. While the broker does not underestimate Cochlear's ability to respond, it notes Advanced has an aggressive 150% sales growth target by 2015. The competitor has matched the features of Cochlear’s N5 behind-the-ear (BTE) processor, in size and directional microphones but has added more, with wireless/inbuilt connectivity to a variety of platforms. UBS finds Cochlear's 67% market share and franchise well entrenched and, despite the recent recall of N5, does not believe Advanced would be in contention for more market share without this new processor. However, the broker sees Cochlear's market share retreating to 60-65%.
BA-ML has delved into Cochlear's high price earnings/valuation metrics. The broker notes the investment case is often made on a pure discounted cash flow basis, struck on such themes as low levels of penetration, market leader status and high barrier to entry with a technology in relative infancy. In this instance the immediate share price value seems to be ignored. However, this is changing. BA-ML believes Cochlear is no longer a pure play, medical technology company. Efficiency factors need to be included in its valuation. This is because developed market growth rates have slowed compared with previous years and volume is more dependent on emerging markets. These markets are focused much more on price.
This will result in greater scrutiny of Cochlear's R&D spending and the scalability and utilisation of the Macquarie University manufacturing hub. The broker does not shy from the possibility that a company can grow earnings in line with volumes, mixing medical technology with efficiency, but with this comes a lower barrier to entry and defensibility from relying on lower price markets for growth. However, if it were that simple, the broker would move to a Sell rating. BA-ML still makes a case for upside risks to out-year earnings and the investment case. Here, Cochlear's ability to capture tender sales in other emerging markets, based on the Chinese tender example, could be quite strong and have a material impact on out-year volumes. Furthermore, BA-ML expects new product launches in 2013 could support and improve developed market growth for the near to medium term.
The upshot is the broker has changed its valuation approach for Cochlear, retaining a Neutral rating and taking a blended price/earnings premium to peer ResMed ((RMD)) with a discounted cash flow. The PE premium to ResMed, the sleep disorder specialist, is set at 20% which provides for 23.9 times against RMD's long term average of 19.9 times. The 20% is in consideration of the two main differences seen between ResMed and Cochlear. Cochlear's area has higher barriers to entry technologically and, in terms of approval processes for new devices, more complex in the cochlear implant versus the sleep apnea space. The second is the lower regulatory risk for Cochlear.
Others make a comparison with ResMed too, mostly in favour of ResMed. Deutsche Bank is wary about Cochlear's earnings growth, with pricing pressure due to emerging markets growth, evidence of share loss, plus the recent competitor product news. The focus on cost containment should support margins, in this broker's view, but it suggests a less confident view on future growth. Deutsche rates Cochlear as a Sell and ResMed as a Buy.
Citi finds the price/earnings multiple too high for the more modest growth outlook. It also prefers ResMed, given its significantly higher earnings growth. Citi forecasts limited earnings growth for Cochlear in FY13 and FY14, due in large part to the roll-off of FX hedging gains, but admits it is difficult to find comparatives given the large China tender win in FY13. The broker believes there is downside risk to its forecasts if Sonova/Advanced Bionics is particularly successful in gaining market share with new products over the next 12-24 months. So, despite Cochlear's price decline after the results, the broker finds the shares still too expensive and retains a Sell rating.
Macquarie didn't like the sales figures in the half year, noting core markets, accounting for 79% of sales, were anaemic, growing just 3.8% on the prior corresponding half. What makes this broker even more concerned is that the previous corresponding period was soft because of the N5 recall, resulting in customer de-stocking. Also, cochlear implant sales, the company's most important product area, were soft, once the China tender is taken out, with units falling 4%. Also, there was no update at the briefing for the reinstatement of N5.
Macquarie says management comment that a high dividend pay-out remains sustainable is "interesting". The broker notes the first half dividend of $1.25 represents a payout-ratio of around 92%. The broker also finds interesting management belief that dividend payments can come from cash reserves. Macquarie admits cost controls were good and had limited impact on margins and Asia Pacific sales were strong, up 33% in constant currency terms. Nevertheless, Macquarie has downgraded Cochlear to Sell, taking the number with that rating to six on the FNArena database. Two retain Hold ratings, CIMB and BA-ML.
A database consensus target of $63.10 sits around 10% below the current trading price.
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