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Aside from fears of reputational damage, one of the big concerns surrounding Cochlear’s recall earlier this year, was how long it would take to return to market.  As you know we purchased shares after the announcement that it had recalled its Nucleus CI500 cochlear implant much to the chagrin of some investors who follow our musings here at the Insights blog.

In NSW every child receives a hearing test within two days of birth.  Those identified as having profound hearing loss are often assisted by Cochlear.  And thats just NSW.  Cochlear sells its devices in 100 countries.  Once implanted changing devices is not easy.  Changing brands may be even harder.  Audiologists and speech pathologists are involved and the devices are finetuned to ensure the device suits the individual.

As Matthew pointed out here on the blog a few days ago:  “A family member [of Matthews’s] is a key member of a large Australian charity that does a lot of work with children that are deaf and many get the implants. All the equipment they use to “map” or finetune the device after implanting is specific to that company. For example the only brand they have is Cochlear. Recently they had a child from the US that they began to support that had a different brand implanted – they had to change many things to be able to help them. When thinking about market share with these devices I think it is important to know that the decision isn’t solely with the surgeon or specialist, because all of the support people have to change too. I don’t think market share will change quickly or by very much because of these barriers.”

Analysts at Macquarie recently surveyed 389 US-based Audiologists. Despite the product recall, Cochlear is still the world leader in CI devices and retains 60% market share selling into 100 countries.  The broker also believes the market is growing at 12 per cent per year.

Many of you know we purchased shares in Cochlear after the September recall (see below), confident this was a temporary issue being treated as permanent by a perennially short-term-focused market.

That now appears to be the case as today’s announcement, posted on the ASX platform by the company reveals; 20122011_COH CI500 impant update

The company previously covered the subject in its AGM presentation here: http://www.cochlear.com/files/assets/corporate/pdf/agm_presentation_18102011.pdf

Analysts were subsequently concerned that 1500 units are going to have to be removed through surgery and another 2800 units have been pulled from shelves. They also worry that an inventory shortfall across the entire market will lead to market share losses from insufficient inventory as well as damage to reputation.

Today’s announcement reveals any small market share loss (we estimate five percent and some analysts suggest between five and ten per cent overall) will be now stemmed by the timely identification of the manufacturing issue that resulted in the failure of 1.9% of devices and their subsequent recall.

Cochlear has ramped up production and its early intervention has enhanced its reputation rather than damaged it as evidenced by several surveys with clinicians.  In fact, 93% of doctors surveyed by Macquarie felt that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.

Ultimately the company’s intrinsic value is determined by its profit and we expect there will be an impact on profit of some import.  Cochlear has already created a provision of $130-$150 million and an after tax cash cost of $20 to $30 million.  Given the news flow that will now transpire, one expects these costs may be treated by analysts as a ‘one-off’ and investors may have to wait for another temporary setback before being able to buy shares cheaply again…

For those of you interested in following our thoughts back in September 14 (COH $51.30), I wrote the following :

“Imagine spending years waiting patiently for the opportunity to buy that rare coin, vintage bottle of wine or celebrated painting, only to be outbid when it finally comes up for auction.

Sometime later the opportunity presents itself again and you are outbid once more, this time by much more. Successive auctions only take the price further out of your reach – if only you acted sooner!

Then one day you stumble across that very thing you desire being offered for sale by someone who appears to have no interest in its long-term value, for a price you regard as a fraction of its real worth.

Would you buy it?

That is the situation I find myself in today as the Cochlear share price plunges another 14% to $51.30, or about 40% since its April 2011 high of $85.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Overnight one of those rivals received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news this week came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors are spooked.

The financial impacts of these events (and there will be an impact) have yet to be quantified so until they are why don’t we look at how the company has performed in the past and see if we can’t learn something about it in the interim.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and last week the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base.

Growth has always been viewed as is limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock yesterday for the Montgomery [Private] Fund. It is likely that I will to add to this position over the coming days and weeks when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall – and there will be one – remains unclear; when that changes it will impact my intrinsic value estimate (UBS has revised its forecast net profit for 2012 by 10.5% to $179.5 million).

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not.”

Source: blog.rogermontgomery.com