Equity Spotlight: Cochlear

This week’s Spotlight will be on a company I believe is probably the best listed stock on the ASX – Cochlear Ltd (COH). Not only is it a great performer, with sound management and excellent returns for shareholders, it is an innovative company that should be a template for how our economy should present itself to the world, given the restraints we have as a small nation. Countries can be evaluated on their strengths like individual businesses – where is Australia’s durable competitive advantage in the world today? It cannot continue to be houses and holes.

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The Business

Cochlear Limited (COH) is a manufacturer and marketer of cochlear implants which are used to stimulate impaired hearing.

COH has a 65-70% global market share of implants, with substantial growth potential in developing markets and continued penetration in developed markets.

Financials

COH has extremely high operating cash flow. Normalised Return on Equity (NROE) is very consistent and is only slightly declining, given the substantial increase in equity over the last five years. Return on Funds Employed (ROFE) is a very high 42%, an indication of very good use of debt. COH’s use of debt is modest, with current net debt to equity ratio at less than 30%.

As a technology company, it is no surprise that COH has a high level of intangible assets. However, these intangibles are outweighed by significant net tangibles and indeed provide economic goodwill evidenced by a very high NROE for a $400 million company.

Reinvestment of capital is always a concern for technology-based companies that must use a fixed or sometimes growing proportion of retained equity in capital expenditure on R&D. COH currently spends about a third of retained profits on R&D – however, this has so far been very beneficial with new products – e.g. the Nucleus 5 implant – becoming profitable very quickly. This is a continued and repetitive good use of retained equity.

COH does not rely on business cycles, commodity prices or other cyclical factors as part of its business model. Although expensive, the implants are usually paid by private health insurance, or heavily subsidised by public health plans. COH has stated they cannot meet current demand as future demand grows, particularly in developing markets. This bodes well for future profitability.

Overall, COH’s balance sheet and financials are very sound, able to cope with any shocks, or expand via acquisitions or continued organic growth. The only concerns are the declining NROE (due to business maturity) and the effects of the AUD/USD exchange rate on profitability.

Management
Management’s performance is reflected in high, sustained NROE, very little acquisition activity and a strong retention of capital, with only minor dilution due to dividend re-investment plans.
However, remuneration is share option based, although not excessive. Further, incremental NROE has declined which implies a higher dividend payout would be prudent, although the retention of cash and a reduced debt-to-equity ratio implies that management have been very skilled at riding out the waves of the GFC.

COH continues to have a great management team with excellent capital management. A move away from share options that dilute company equity and can provide perverse incentives (although this has not been the case here) would solidify their position as Corporate Australia’s best team.

Key Risks and Opportunities

  • Has a well-established and trusted brand name for superior goods and technology
  • Recipients of implants are either non-price sensitive or paid for by others (charity/government)
  • Increasing customer base that COH cannot keep up supply
  • A strong and continued focus on R&D that pays benefits
  • Continued AUD/USD and AUD/EUD appreciation, where in total, over 80% of company revenue is sourced, has an adverse impact on revenue
  • Competitors may produce a better technology, which requires COH to maintain a very high amount of capital investment in Research and Development
  • Government intervention in expensive health care costs could force COH to reduce prices and affect profitability

Climbing the Ladder to the top
COH is considered a “Wonderful” company due to its sizeable competitive advantage – a superior, price-setting product with large demand – its excellent financials, capital management and management team. A top grade is only out of its grasp due to the exchange rate risk and the ever present sovereign/legislative risk that surrounds the fettered healthcare market.

Valuation
Using an adjusted average Price/Earnings (PE) ratio of 23, and forecast NROE of approx. 48-55% (declining as equity per share increases) Empire values COH at $83 per share until the next earnings report (scheduled for early August). COH has a history of being “bid-up” by the market, with price/value convergences rare.

At a standard 10% discount for “Wonderful” companies, our maximum buy price would be $76 (i.e we would accumulate at any price below this level).

However, the foreign exchange risk implies purchasing COH shares at a slightly higher margin of safety, so we believe COH is excellent value at any price below $73. Cochlear recently closed below this level, and is currently trading at $72.12

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has an interest in the business mentioned in this article. The author also has a sizeable stake in his family’s super fund and will purchase more in the future. The article is not to be taken as investment advice and the views expressed are opinions only. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

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Comments

  1. The next earnings report will be informative given the high and sustained AUD. COH has hedged very well in the past, which is a huge plus given 2/3 of their revenue is offshore. However, I presume their hedging positions aren’t indefinite so a sustained high AUD will have an impact at some stage.

    • Ok I’m confused now. Prince above says:

      Continued AUD/USD and AUD/EUD appreciation, where 40% of company revenue is sourced, has an adverse impact on revenue

      Does that mean 40% of revenue comes from the US and Europe, or 40% comes from Europe?

      I presume their hedging positions aren’t indefinite so a sustained high AUD will have an impact at some stage.

      Well said Q. I’m tired of mining fanboys saying manufacturers and other non-resources exporters should hedge. HTH do you hedge against a long-term step change in the currency from 70-odd cents for the past 20 years, to above parity for the foreseeable future?

      Answer: You close operations in Australia and move elsewhere.

      • Hey Lorax – from FY10 annual report, 44% of revenue comes from the Americas and 42% from Europe, with the remainder attributed to the Asia PAcific region. Total revenues were $696m.

        • Thanks, so 86% of revenue from Europe and America and some portion of the rest from Asia Pacific countries that currencies that have weakened against the AUD. I think we can safely say more than 90% of revenues are from countries with weaker currencies.

          over 50% of their costs is in marketing and sales, mostly overseas. This has cushioned them against the high $A.

          So? The answer is still to cut where you’re costs are blowing out, and that would be Australian-based R&D. The logical answer is to start moving your R&D offshore.

          That’s the price we pay for being a Quarry Economy.

        • Updated the post – sorry about the grammar (it was half written by an engineer…)

          Lorax, I agree with you, and it makes COH’s performance all the more better, being able to manufacture in Australia (gasp!) a high end product and then sell it overseas to countries with anemic currencies, yet can’t fill the demand….

          And yet somehow this sort of company is told by all and sundry to stand aside for a short term (in the scheme of things) boom in resource extraction…..

          In times like this, it makes sense to re-structure not for the boom, but for after and make sure more companies like COH can be started and flourish.

      • That depends a lot on where your expenses are incurred and the nature of those expenses. In Cochlear’s case, over 50% of their costs is in marketing and sales, mostly overseas. This has cushioned them against the high $A.

  2. While I agree with your assessment of Cochlear as one of (if not the best) publicly listed companies, I do however have doubts about the valuation.

    I understand your rational for using a terminal PE multiplier, but because the terminal value plays a large part in determining the present value, I think it pays to interrogate the assumptions in this number.

    Given a terminal multiple of 25, and a conservative discount rate of 15%, this implies an earnings growth rate of 11% (1/25=4%=15%-11%). In perpetuity. For ever and ever. Cochlear is good, but not that good I’m afraid. Mathematically, no company can grow at greater than the rate of GDP for ever.

    Lets try some other numbers – say you have a lower required rate of return – say 9%. Then the perpetual growth rate comes down to 5%. This is still more than you can expect from the economy, and your premium over the risk free rate is now becoming quite thin.

    If you think Cochlear can continue it’s excess growth rates (and eventually become the economy) then a terminal earnings multiple of 25-odd is fine. Alternatively, increase the high growth rate projection (based on ROE re-investment) out to maybe 10 years before putting them into a more conservative stable growth path.

    Apologies for the techie quibbles, but I guess disagreement on future cash flows is what makes a market right?

  3. Hi Lighter

    No apologies necessary – debate and exchange of ideas is the lifeblood of progress. We don’t assume ROE’s for perpetuity because of the basic math behind compounding as well as the fact very, very few companies last longer than 20 or 30 years. That said, it is possible for companies to have very long periods of above-market returns as evidenced by Berkshire Hathaway (as rare as they may be). There are a lot of companies out there who also do below-average returns, so someone has to counterbalance them in order for the market average to be what it is!

    With regards to timeframes, we look at a 5 year ROE forecasts which will invariably change with earnings updates and major news. No doubt at some point in the future when the implant market is saturated, COH has a seriously good competitor, after a long period of high AUD or another technology comes along, ROE will trend down even further. And we’ll adjust our valuations down all the way – we’ll never claim to be able to pick a winner 10 or 20 years out. But at the mo, we like COH and would love it more were it not for the forex risk.

    • Also, CAGR of normalised earnings has averaged 20% per year over the last 10 years. Even still, as QC pointed out, we only use a 5 year timeframe, to take advantage of medium term pricing inefficiencies.

      Our Normalised EPS assumptions are about half that, and are effected by reduced franking on dividends and a changing reinvestment ratio going forward as the business matures. This can be effected by putting more cashflow into R&D which is a concern.

      I apologise for the 25 Adjusted P/E – that was incorrect – we recently reduced this to 23, but hadn’t updated our public file.

    • Lighter Fluid

      Thanks P and Q,

      I agree that attempting to predict any further out than a few years is folly. Hell, I don’t even know what 2012 will bring, let alone 2020. This is why I try to avoid DCF as much as I can – particularly due to the terminal multiplier effect I mentioned above.

      Using a terminal PE value, be it a 1-year forward PE, at year 2, year 5 or year 10, (even if it is a historically low PE) converts an intrinsic valuation (a business in a vacuum) to a closet relative valuation (what the market thinks it’s worth). That is unless you are comfortable with the growth rates implied in that multiple (a PE ratio is just a simple DCF in disguise).

      That’s not to say I don’t like growth, but I’m skeptical in looking for my margin of safety there. If at all possible I’d prefer not to pay for growth.

      Where I do find DCF useful is in reverse. Ie – working out what kind of growth rates are assumed in the current price and how detached (or not) from reality they are.

      • Agreed Lighter – the purist in me hates the use of PE ratios, but the realist in me does not believe in eternal companies, immortal investors or that the market can be ignored completey. At some point in the future we’ll be selling our current investments and we need to estimate at what price in order to determine a value.

        I’ll still pay for a company that has a durable competitive advantges and a history of equity and earnings growth though.

  4. Wow! I thought I would never hear the relative valuation metrics coming from The Prince..I think Q summed it up nice in his last comment regarding eternal companies and irrational investors..

    What do you guys think about capitalizing R&D expense over the years? IMHO the NUMBER that market looks for is EPS and a value investor looks for is ROE. Essentially P&L related, directly or indirectly.

    It is R&D that has allowed this sustained earnings profile to eventuate. Expending the same just leaves a game of hope as to if they come up with the next big thing. Capitalizing it and calculating adjusted earnings and equity base provides more realistic measure of injection that company has put in to generate these mega earnings trends (ie CAGR of 10% of more for sustained periods).

    Another positive I see to is that if say next few years don’t provide a payoff in terms of patented technology or further enhancements, then a capitalizing approach would have at least factored in the growing equity base that the company was accumulating in an attempt to produce returns. It will show up in declining ROE measures.

    All of this is not against the admirable business that COH or say CSL possess, but just expressing my opinion as to how the return on investment could be better captured. I know Prince always argues that mechanics are not as important as dynamics of the business, but thought I would throw it out for discussion…

    Cheers,

  5. Can you explain how you are calculating ROE?

    According to the figures I can find, COH’s eps for the last FY was $2.742 with a book value of $7.75.

    Dividing the two you end up with a ROE of 35.38% which is what is also reported in eTrade, the online broker I use. This is no where near the 49.5% you specify in this article.