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Aussie Peripheral: Cochlear Update


Last Price: A$189.65 (Investment view as at 27/11/18 when price was A$169.19) 
Sector: Healthcare
Market Cap $10,954 M
Fair Value A$180


Investment Perspective
Cochlear is a global leader in the design and production of hearing implants, with an almost-unblemished track record until the recall of the Nucleus 5 implant in 2011. Notably, the recall was voluntary and was based on adverse results in less than 1% of products issued. Management's conservative decision to voluntarily recall the product preserved customer goodwill, despite the temporarily negative impact to investor sentiment and revenue. After a sharp decline in its stock price in response to the recall, the shares have regained momentum, increasing 365% between 30 September 2011 and their high of A$215 on 30 August 2018. With strong medium and long-term growth prospects and enviable market leadership, the continuing market weakness and recent court case (Cochlear is down 22%) may produce a buying opportunity. Cochlear's moat is underpinned by switching costs and intangibles and the firm's dedication to research and development drives product innovation, supporting an intangible moat source. Switching costs are high among medical practitioners and those already with implants.


Company update
Court Case a Minor Sped Bump for Cochlear;
Cochlear has been ordered by the U.S. District Court to pay USD 268 million in damages to the Alfred E. Mann Foundation for Scientific Research and Advanced Bionics due to patent infringement. Cochlear will appeal the judgment with an outcome expected in about two years. Importantly, the damages relate to an expired patent and the ruling should not impact Cochlear's future business. Cochlear disagrees with the reasons for the damages and will take the case to the U.S. Court of Appeals. Pending the outcome of the proceedings, Cochlear will lodge a USD 335 million insurance bond with the Court. The potential damages are not sufficiently material to warrant a change and we reiterate our AUD 180 per share fair value estimate. If Cochlear is required to pay the full amount it would equate to just a 3% impact to our fair value estimate. However, the case has been the subject to several hearings and an appeal. Our view is Cochlear will need to pay a significantly smaller amount, which is likely immaterial to our fair value estimate. Cochlear intends to assess the current AUD 21.3 million provision for this case and provide an update to the market. We expect the provision to increase but remain modest. The primary impact to Cochlear is the payment of the USD 355 million bond. The company's balance sheet will weaken somewhat with the outflow; however, it will still be robust. Net debt at the end of June 2018 was AUD 86 million. This grows to approximately AUD 560 million by the end of fiscal 2019 due to the bond, but debt metrics remain comfortable. Net debt/EBITDA is forecast to peak at 1.3 in fiscal 2019, declining to 0.6 by end fiscal 2021 when the damages settle. EBIT/net interest expense troughs at 11 in fiscal 2019, still comfortable, particularly for a business of Cochlear's quality.

 

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