Cochlear Confidence Falls On Deaf Ears

This story features COCHLEAR LIMITED. For more info SHARE ANALYSIS: COH

-Market share loss continues
-Partial N6 approval in US
-Upgrade potential weak
-Dividend maintenance a positive
 

By Eva Brocklehurst

It's tough at the top. The recent AGM revealed Cochlear ((COH)) is struggling to stay at the pinnacle of hearing implant providers. The company expects little, if any, profit growth in FY14. Brokers had softened their stance after the FY13 results, eagerly awaiting the prospective launch of the Nucleus 6 processor. It would seem they are hardening again, as the competition onslaught continues relentlessly amid some delay to the full offering of the N6.

On the FNArena database the red ink of the Sell side is almost universal. There are seven Sell ratings and just one Hold. JP Morgan has downgraded the stock (to Underweight from Neutral), on concerns about the impact of competition on market share. The broker had upgraded the rating after FY13 result and was hoping the launch of the N6 processor may be able to claw back some market share. Now it doesn't look so promising. Partial approval of the N6 in the US is not a good position to be in, and the broker suspects damage to Cochlear's reputation.

Back at the FY13 result it was apparent to many brokers that the re-rating would rely heavily on the success of the Nucleus 6. Management had provided no guidance at the result. Two months later, brokers ares disappointed with the fact the company expects no growth in profit for FY14. The first quarter's sales were never expected to be underpinned by the N6 but the partial approval by the FDA has been unfortunate in its timing. In the US, the product is being marketed as "wireless-ready" whilst FDA approval is pending. The FDA is yet to approve the "scene classifier" as well as the rechargeable batteries. The earliest timing for FDA approval of the full suite of N6 capabilities is November 2013, followed by a re-release date in February 2014.

Credit Suisse also has questions over the company's market share and growth. The broker commends the AGM updates on new products, with the BAHA 4 system to be launched next month in the US and Europe following regulatory approvals. The Codacs acoustic implant will be used for the first time in surgery this month and the former Otologics middle ear implant is returning to market. The hybrid (EAS) device application has been filed with the US FDA and a meeting is scheduled for later this year. All these products offer potential growth but Credit Suisse expects the next 12 months will still be a question of how successful the company is in stemming the market share loss in the key cochlear implant category.

Management announced a heavy bias in profits to the second half. Morgan Stanley considers this may be due, in part, to negative foreign exchange hedges and the fact the US launch of N6 has only been recent, but it does not counter the risk that new guidance is dependent on backwards-compatible success. The broker thinks the recent N5 upgrade cycle means time-limited insurance programs may prevent short-term N6 speech processor upgrades and, with no Chinese order either, the downside risks are weighty. The broker contends Cochlear will have to gain market share just to deliver flat unit numbers.

Oh, the weight of competition. JP Morgan observes the company has been wrong-footed in the US following the roll out of the Naida processor by AB/Sonova, which appears to have been well received, and suspects this forced Cochlear to release a partially-approved N6 in an attempt to stop the loss of market share. Competition is increasing across all of major markets, with MedEL taking share in Europe and the company missing out on the remaining tender contract sales in China. Morgan Stanley also observes that MedEL is becoming more of a threat and Advanced Bionics has an aggressive product pipeline. The broker believes that the changing demographics for cochlear implants, with a focus on older patients, is likely to benefit competitors which offer a broad spectrum of hearing solutions.

CIMB accepted that management addressed some of these well-flagged challenges at the AGM but cannot dismiss the headwinds of market share losses, the lack of a strong upgrade cycle and the reliance on emerging markets. The risk/reward profile of the stock remains unfavourable with the share trading at 24.6 times forward earnings. BA-Merrill Lynch had been expecting heightened earnings risk and the AGM has confirmed it. A weak first half means performance in the second half has to rebound strongly to achieve flat earnings growth. If the company can demonstrate a strong second quarter run rate then the risk to Merrills' Underperform rating turns positive, especially looking ahead to FY15. It's a big ask. Until the broker is able to envisage the new growth initiatives more comprehensively a cautious course must be steered.

Despite the earnings pressure, the board will maintain dividends and intends to declare both an interim and final dividend of $1.27 in FY14. This suggests a pay-out ratio that's greater than 100%, but the board appears comfortable introducing a small amount of debt onto the balance sheet to support the dividend yield. On the FNArena database, consensus FY14 and FY15 earnings estimates put the dividend yield at 4.4% and 4.5% respectively. The consensus target price is $53.30, suggesting 8% downside to the last share price. This compares with $54.55 ahead of the AGM.
 

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