Back in September, I posted on the recall of Cochlear’s Nucleus 5 implant – COH’s primary device which makes up the lion’s share of Cochlear’s revenues (see full article here). Since the recall there has been no other information released by Cochlear, who promised to give an update at the AGM.
Well, the AGM was held yesterday and investors were waiting with baited breath (yours truly included).
The headline financial information for FY11 is as follows:
- Revenue up 10% to $809.6 million
- Implant sale sup 17%
- Net profit after tax (NPAT) up 16% to $180.1 million
- FY11 final dividend increased 14% to $1.20
- Total FY11 dividend was $2.25 – an increase of 12.5%
The all-important recall information is summarised below:
- In the period leading up to 11th September 2011 there was an increased rate of failure of the CI series implant (already known)
- The CI 24RE implant was used as a substitute, with no loss in hearing performance over the CI 500 unit (already known)
- Cochlear believes it has covered financial and liquidity issues and have considered the likely market impacts and other variables
- A one-off cost (provision) of $130 to $150 million has been allowed for the recall – this includes costs relating to the recall, stock write-offs, other related write-offs/impairments and other costs that may be incurred over time, as well as non-cash items (presumably intangible asset)
- They expect the provision to have an after-tax impact of $20 to $30 million
- Cochlear will pay a $1.20 dividend for the interim of FY12, and will keep dividends at this level until further information on the recall impact comes to light or performance drops substantially
To be honest, I was a bit underwhelmed by the recall update. Whilst Cochlear have provided a cost assessment on the update, there are still a couple of unanswered questions like:
- An update on the failure rate of the implanted CI 500 units – is it still below 1%? I am sure existing recipients would like to know
- Whether any progress had been made on identifying and fixing the underlying issue with the CI 500 implant
- Whether the CI 24RE implant was a permanent solution or a stopgap
Taking the recall information at face value, the $20 – $30m impact represents about 16% of FY11 NPAT (at the upper range of the estimate). All things being equal, this should impact ROE in FY12 by about 16% too. Given that COH’s normalised ROE (inc. franking credits) has hovered between 35 and 30% for the last 5 years, we could sensibly forecast a FY12 ROE of about 30 – 35% based on the provision. The real question is what impact the recall will have in years FY13 and onwards. Will ROE return to historical norms above 40%, or will it be permanently suppressed?
Personally, I think COH will overcome the problem and return to higher ROE’s within a few years. This judgement is based on the calibre of the management, Cochlear’s reputation as an industry leader, its high levels of R&D expenditure and the fact it has pre-empted the recall rather than having it forced on them. I also see it as a hedge against a falling AUD, as +80% of their revenues are form offshore.
Assuming normalised ROE starts at 30% and increases back to 40% over 5 years, using a current equity per share level of $8.88 and a reinvestment ratio around 30%, I value Cochlear around $61.00.
As I stated in the previous article, I think the market oversold COH by a substantial margin – especially in the weeks following the recall, which coincided with a big market correction. I believe anyone who bought COH with a 4 in front of the share price got themselves a bargain. The current dividend yield is 4.8%, which is a dividend huggers delight for what is still a “growth” stock that is reinvesting large amounts of NPAT for good ROE. Even at current prices, I think COH is a pretty decent buy for the long term investor.
Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has currently has an interest in the businesses mentioned in this article. The author also has a personal interest in the business mentioned in this article. 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.