Cochlear Limited is an unpredictable behemoth

Cochlear piqued my interest when I heard there was a massive earnings miss and a large decline in the share price. The market punishes blue chip darlings when they miss earnings expectations; especially when they have a track record of meeting them. I thought this might be an opportunity to buy a high quality business at a reasonable price.

The de-rating was promising; with the core valuation dropped 50-60%, to all time lows (approximately 2.8x EV/Revenue and 20x profits). The annual report, boasted a large and under-penetrated market of the hearing-impaired with wonderful economics, a dominant market position, scale advantages and high barriers to entry. The company targets an 18% underlying profit margin, with anything beyond that re-invested into growing their market and research which I felt would further entrench their market leadership. My research has given me confidence they are the undisputed market leader for cochlear implants, but I am less certain about the predictability and growth of their business.

Cochlear’s management pitch it like this; there is a large, untreated market with only 4% penetration for Cochlear’s products, cochlear is the market leader and over time volumes should grow. Their stated target is to treat 8% more patients each year, which is impressive.

The way I see it, the picture is not as simple. There is a large sea of untreated people who could benefit from Cochlear’s products, but there is significant uncertainty these people would be able and willing to be treated with Cochlear’s implants. There is great uncertainty how much of this untreated population want to be served, and when they will be served that makes Cochlear a very hard company for me to understand how the future looks. The three stages of the treatment process are what I think about as challenges to Cochlear’s opportunity to serve their market and I believe there are significant question marks against their ability to serve each of them.

Firstly, Patients must be aware of their hearing loss and be able and willing to seek help. The Company invests significant resources raising awareness of the health risks of untreated hearing loss, which should raise awareness for hearing loss treatment over time and increase the number of people seeking help. However evidence isn’t clear that Cochlear implants alone are effective in mitigating hearing loss and it’s side effects.

Second, Medical professionals need to be aware of Cochlear’s products and recommend them over alternatives. While the Company is the leader in it’s field and they have an advantage over rivals in their marketing and education activities, medical or technology changes can render their advantages obsolete and substantially reduce their addressable market overnight, if medical practitioners find a cheaper and less invasive method of treating hearing loss.

Thirdly, patients must be able and willing to pay the cost and associated risks in comparison to alternative treatments. Because of the large cost of the implants, government subsidies and insurance coverage significantly increase or decrease uptake and make future demand reliant on policy continuity. Economic shocks are also likely to cause patients to postpone treatment, or opt for cheaper treatments. The Company can soften these factors by providing patients with credit, to lower the upfront cost and accelerate growth, but this would increase the capital required to grow the business and lower profitability.

This is an interesting business, that appears very high quality but operates in a very complicated market and has many moving parts. I would need to undertake significant work to be comfortable making an investment in Cochlear but I am intrigued by the business dynamics.