Doubts Linger Over Cochlear

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

-Upgrades contribute 15% in H2
-Top line growth elusive
-Reverting to lower pay-out ratio
-Stock is expensive

By Eva Brocklehurst

Cochlear ((COH)) surprised the market with a better performance in the second half of FY14, at least in terms of delivering on earnings guidance. In the matter of market share the company's position continues to deteriorate. Brokers also remain concerned about the growth of the key cochlear implants business, as new products and upgrades appear to be driving sales momentum.

While the rate of growth was slower than historical levels of 5-10%, BA-Merrill Lynch observes one positive aspect in that this shifts the focus onto the rate of growth, rather than market share loss. A return to growth mitigates an Underperform call but the broker believes a Buy call is equally challenging. Hence, Merrills sticks with a Neutral rating. Cochlear benefited from increased upgrade sales emanating from the N6 processor launch.

The company revealed for the first time that upgrades contributed around 15% of revenue in the second half and the broker believes this was a material contributor to gross margins. Merrills expects upgrades to remain a key growth factor and earnings should grow faster than sales. The broker remains optimistic regarding Cochlear's direct clinic involvement, that is its Melbourne Cochlear Care Centre, but does not envisage the current level of spending on this growth initiative will have much impact on the status quo.

Deutsche Bank is disappointed with the fact the company continues to lose market share. The broker wants evidence that new products are providing a meaningful boost to earnings. Sales momentum was disappointing but the broker acknowledges lower operating costs, in part reflecting low costs associated with the Chinese tender sales, allowed profit to beat forecasts. Second half revenue growth was a solid 16% and Deutsche Bank expects this momentum should carry into FY15, supported by upgrades, new products and associated regulatory approvals, particularly in the US.

Relative to Macquarie's expectations, sales were only marginally ahead in FY14 with the main driver of the better-than-expected performance being gross margin and a lower tax rate. The broker's primary concern is that top line growth is elusive and inconsistent with the stock's price/earnings ratio. Moreover, the company announced the dividend pay-out ratio for FY15 will revert to historical norms of 70%. This equates to $1.69 in FY14 in Macquarie's calculations, a 33% reduction from FY14. The broker suspects this will raise further concerns about the growth outlook.

Management has signalled investment in technology and improved patient outcomes as its key strategy for growth but Macquarie is not overly confident. The rate of innovation in cochlear implants is slowing and product features are not a large driver of industry growth, so the broker struggles to accept the company's ongoing high expenditure in research and development. Macquarie would prefer to see development of an effective channel to reach the large under-penetrated adult segment but accepts this seems to be a low priority for management.

Sales were ahead of Citi's expectations, sufficient to meet guidance. The broker liked the result after a disappointing first half, although acknowledged growth in the key cochlear implants is still missing. Market share appears to be stabilising but Citi wonders whether this can improve, given ongoing competitive pressures. The broker does not believe N6 upgrades, which will drive a material improvement in sales and profits for FY15, are enough. Implant units will need to grow to drive sales and earnings thereafter. Citi, too, would like to see new approaches regarding penetrating the adult segment. The broker considers the stock expensive, particularly in view of the risks, including US Medicare ceasing to cover acoustic implants or patent litigation that is unfavourable to Cochlear, as well as the market share onslaught from competitors. Citi retains a Sell rating.

JP Morgan is most encouraged by the momentum in processor upgrade sales and gross margin improvement. Still, the most valuable part of the business is the implants and here the company lost market share. The broker believes the company could be at the point of delivering more impressive growth numbers, assuming product releases are a success, but it is too risk to take a punt on this basis because the stock is expensive. An Underweight rating is retained.

UBS revises up forecasts to take account of stronger contributions from upgrades but maintains the consensus profit target of $140.2m for FY15 is a stretch. Moreover, the company's price/earnings premium of 80% to the ASX Industrials ex Financials comes despite a three-year decline in earnings growth. The broker notes cyclical upgrades deliver only a short-term boost to earnings, while the success of the N6 launch is not yet apparent. CIMB retains a similar view, noting volatility and a lack of earnings visibility are risks that are not adequately reflected in the share price.

Cochlear entered its result release as the most shorted stock in the market by a margin, at 17.8% shorted (See FNArena's weekly Short Report). Those short positions had to be covered in the wake of the results and the resultant buying produced a subsequent rally in the share price. On FNArena's database there are no Buy ratings, just two Hold and six Sell ratings. The consensus target is $57.78, suggesting 17.8% downside to the last share price, and compares with $51.86 ahead of the results. The targets range from $49.49 (Citi) to $69.65 (Merrills).
 

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