Australia | Feb 12 2014
-Questions over quality, sustainability of growth
-Uncertainty regarding further downgrades
-Key to turnaround is in FY15
By Eva Brocklehurst
Disappointing was the buzz word around Cochlear's ((COH)) first half. Brokers came away with the impression there's a lot hinging on the promise implied by an improved sales trend in the second quarter. Will this be enough to stave off the bleeding in the company's market share and turn around the growth outlook? Only a few are prepared to assume the worst is over.
BA-Merrill Lynch decided to upgrade the stock to Neutral from Underperform. The broker thinks that despite ongoing concerns about the outlook and the downgrade to FY14 guidance, the run rate is improving. This should herald a meaningful uplift in FY15. Still, Neutral is the cautious call, as Merrills considers the optimism is largely predicated on a declaration by Cochlear that the second quarter was much better. This doesn't answer the broker's questions regarding the contributions to weakness in the first quarter. So, no Buy yet. What is critical to Merrills' thesis is the growth rate in the industry, overall. The improvements in the second quarter, and hence the FY15 tailwinds that are envisaged, are too specific to the company. Merrills wants to know what the shift to lower-value markets means and observes there has been little that the industry has done to reverse or improve on this trend.
It's the third FY14 downgrade in nine months and because of ongoing competitive pressures, lack of transparency and a lofty multiple, the risk is outweighing the reward in Morgan Stanley's view. The broker acknowledges there may be some share price recovery in the short term but competitive pressures over the longer-term underpin an Underweight rating. Furthermore, ongoing patent disputes and risk of associated charges limits the flexibility of the balance sheet. For Deutsche Bank the key issue was higher expenses in the first half, especially in manufacturing. This will need to normalise in the second half to deliver on guidance, according to the broker.
JP Morgan also felt the time was ripe for an upgrade – to Neutral from Underweight. The result may have disappointed and validated the belief that competition has increased significantly but the broker is prepared to accept a bottom of the cycle in earnings may have passed. Momentum appears to be improving and FY15 shaping up for growth. The broker noted delays at the FDA in approving the features of the N6 have not helped but management now expects approval in the first half of FY15 and that should drive growth. The broker observes from its survey last month of audiologists in the US that the N6 received a good reception despite the delays and this supports the notion it remains viable in the US.
Citi found the first half sales very disappointing. Excluding Chinese tenders the cochlear implant unit sales were flat. The broker fears Cochlear is clearly losing market share, predominantly in the US and the pre-launch of N6 seems to have contributed to this. The full features of the N6 will not be available until FY15, and patients appear to be holding off for the new product. The broker does not expect N6 upgrade sales to contribute significantly until FY15.
On the positive side, Citi thinks the company can deliver on expectations in FY15 if the upgrades are successful and market share loss can be stabilised. In terms of the latter, a new implant may be required to achieve this stability and the broker does not rule this out as a possibility. Citi's fundamental query is around whether the earnings shortfall seen in the first half can be recovered by a return to sales growth. Achieving such sales growth may be problematic. Hence, the broker thinks investors should be seeking a bigger discount in the price, given the uncertainties.
Time is needed for the new CI units to gain traction, while the uncertainty is increased amidst a growing reliance on emerging markets and the uptake of units in adults, in CIMB's opinion. Sure, new products, the 30% sequential increase in second quarter sales and an impending upgrade cycle in implants all look to be supportive, but the broker is unsure whether this will be the last downgrade to FY14 guidance. Credit Suisse has a host of worries too, citing many issues that need to be resolved before there's some clear air on the stock and a re-rating can occur. These issues include a stabilising of market share, formal approval of the N6 processor, resolution of patent infringement and lawsuits, as well as improvement in converting earnings to cash flow. Then there's also the foreign exchange factor and the question of why this, plus fewer unit sales, had such an impact on gross margins.
Cochlear stated that the dividend will be frozen at 127c per half until earnings recover to support a 70% pay-out ratio, which UBS estimates will not occur until FY18. The broker sees the company inching towards more realistic guidance but this hinges on the N6 launch reinvigorating growth. From UBS' calculations the numbers that are required stack up to a big challenge. The other item of note for the broker was the reduction in first half margins, affected by the costs of launch, high cost of goods sold in terms of a loss of manufacturing scale, as well as other input costs. UBS maintains that Cochlear's risk profile has changed, so valuation should de-rate towards peer multiples. Moreover, the expected FY15 recovery is predicated on cyclical gains from the rolling of FX hedges and an N6 upgrade cycle, not underlying unit sales. It all adds up to a Sell rating for UBS, one of the five on the FNArena database. There are three Hold ratings and no Buy.
Is there are more positive outlook? Macquarie thinks investors could become a little more positive, as the company believes the growing pains with new product launches are now behind it and strong momentum from the second quarter sales can also address the margin issues and deliver a substantial increase in second half earnings. Still, Macquarie struggles with the multiples for the stock, as unit sales have been flat for the past three years. Cochlear may be looking cheaper on a relative basis but the broker suspects the stock will stay around current levels in the near future. The broker maintains a Neutral rating.
On the FNArena database the consensus target is $51.56, suggesting 7.1% downside to the last share price. This target has fallen from $54.08 ahead of the results. Targets range from $47.29 (CIMB) to $55.02 (JP Morgan). The dividend yield on both FY14 and FY15 forecasts is 4.6%.
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