Wide-moat Cochlear (ASX: COH) grew interim 2024 underlying net profit after tax strongly by 21% to $192 million. This was driven by revenue growth of 20% on strong market demand for cochlear implants and sound processor upgrades.

The firm reiterated its fiscal 2024 underlying net profit after taxes (“NPAT”) guidance range of $385 million to¬ $400 million, implying -26% to 31% growth on fiscal 2023. We maintain our $220 fair value estimate and leave our forecast free cash flows broadly unchanged.

Shares remain overvalued with current earnings growth unlikely to be maintained. First-half Cochlear implants sold were up 14%, but benefited from surgical backlogs that are still clearing and elevated demand for the Nucleus 8 sound processor, launched in second-quarter fiscal 2023.

Market growth in the U.S. is particularly strong with the U.S. recently lowering the age of cochlear implantation to 9-12 months, including single-sided deafness as an indication. Partly due to these factors, management still expects volume growth to moderate to high single digits over the longer term. We also expect sales growth to moderate and forecast a five-year group revenue compounded annual growth rate (“CAGR”) of 11%.

The interim dividend increased 29% to $2.00 per share, 70% franked, broadly in line with higher earnings and representing a 68% payout on underlying NPAT. Cochlear is in strong financial shape with $485 million in net cash at the half-end. We expect Cochlear to maintain its net cash position and comfortably service our unchanged forecast 70% dividend payout to fiscal 2033. This translates into dividends growing at a 10-year CAGR of 11%.

Business strategy and outlook

Cochlear is the market leader in cochlear implants with consistent share of roughly 60% across developed markets. Cochlear implants became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market segment largely penetrated, the company is looking elsewhere for growth with developed-markets adults the next primary focus and emerging-markets children after that.

We estimate roughly 70% of units are sold to developed markets and the remaining 30% to emerging markets, where over 90% are for children. Large price differentials in the lower range of products result in 80% of revenue being earned in developed markets and 20% in tender-oriented emerging markets. We estimate average unit prices achieved in developed markets are double those in emerging markets.

In the developed-markets children segment, the growth tailwinds from increasing market penetration and the shift from single to bilateral implants over the last 15 years have played out, and we forecast growth in this segment to reduce to the birthrate over time.

The adult developed market is more difficult to penetrate, and we expect required investment to expand this segment will restrain significant operating margin expansion.

Currently, penetration is still estimated to be under 5%, and Cochlear is at a pivot point as it invests to be adopted more widely by seniors with profound hearing loss.

Prevalence of profound hearing loss increases over 65 years and has a steep increase over 80 years of age. As such, an ageing population and low penetration suggest a large opportunity. However, hearing aids, not cochlear implants, are the standard of care. Cochlear is investing significantly to increase awareness as well as funding research to support payer reimbursement. But we see two main challenges to accessing this market fully: first, the relatively low willingness of older candidates to undertake such invasive surgery, and second, the improvements in hearing aids. The hearing aid market is increasing its penetration in the severe hearing loss category, leaving only the smaller profound hearing loss as the cochlear implant niche.

Economic moat

Read more about how identifying a company with a moat impacts investment results.

We award Cochlear a wide moat rating and think the combination of its intangible assets, namely brand, and switching costs will help deliver maintainable excess returns. The company earns an increasing proportion of its revenue from sound processor upgrades and accessories used in the growing global installed base of over 600,000 implants, most of which are cochlear implants.

We forecast this annuitylike revenue stream to contribute 37% of group revenue by fiscal 2030 from 29% in fiscal 2020. Importantly, non-Cochlear sound processors and accessories are not compatible with Cochlear’s implants. In addition, once a patient receives a Cochlear implant, switching costs such as the inconvenience, risk, time, and money of further invasive surgery is likely to prevent the patient switching to an alternative device for their entire life span. This is further strengthened by external sound processor upgrades being available that improve with technological advancement over time. Thus, we see the services segment being largely unaffected for over 20 years.

We think the combination of brand loyalty and switching costs is also strong enough to support device sales over its competitors for well over 10 years, hence further growing its installed base and driving services revenue. Cochlear has consistently maintained a dominant 60% market share among the big four players within the cochlear implant market, compared with MED-EL with roughly 20%, Advanced Bionics at 15%, and Demant at 5%.

A voluntary product recall in fiscal 2012 dented profits but only had a temporary impact on market share, which is evidence of brand loyalty and switching costs. Switching costs extend to the developed market surgeons as they are familiar and trained to implant Cochlear’s devices.

Cochlear is said to require exclusivity from key clinics and sees virtually no brand switching, with surgeons also remaining loyal to the brand from grown trust and experience in its products. As such, we do not expect significant market share to be ceded over the forecast period. Pricing is relatively stable and not a major differentiator across competitors in developed markets as most sales are reimbursed by government-funded health care or private health insurance. Gross margins within the industry are also high, with Cochlear averaging 73% over the last five years and second-largest competitor, MED-EL, recording 67% in fiscal 2017.

Due to its dominant market share, high gross margins and relatively low invested capital, the company, bar fiscal 2020, has posted a return on invested capital above 30% on average over the last decade. Even in fiscal 2020, when elective surgeries were largely halted in most developed countries for over a quarter of the year, ROIC was marginally ahead of its weighted cost of capital of 7.4%. We anticipate the company’s ROIC to far exceed its WACC over our 10-year explicit forecast period, even in our bear-case scenario.

Nurotron, a Chinese competitor, targets volumes in the China tender market with a cheaper product offering. The company licenses intellectual property from an American university and does not conduct its own research and development, or R&D. Nurotron’s tender winning price of $5,500 US per unit compares with Cochlear’s average China-tender unit price of $6,000 US, but is significantly below our estimates of Cochlear’s developed market unit price of roughly $21,000 US and emerging-markets unit price of roughly $11,000 US.

As Nurotron’s devices are not U.S. FDA-approved, we anticipate them being a bigger threat in tender-driven emerging markets, in which Cochlear generates 20% of its revenue. While it’s possible Nurotron will eventually enter the U.S. market, given the rigorous and lengthy approval pathways and Cochlear’s dominant market share to compete with, we think it’s unlikely Nurotron will pose a significant threat. Cochlear’s margins are higher than peers and will be able to better withstand potential price deflation, and its trusted brand reputation together with reimbursement support will help maintain its dominant market position, as evidenced even through the fiscal 2012 product recall.

Intangible assets stemming from technical product differentiation and patent protection are less of a moat source. Although the company touts the superior hearing outcomes, reliability and technical differences between its products and peers, short-term market share shifts based on product launch cycles suggest intangible assets based on product differentiation are not Cochlear’s key competitive advantage.

Cochlear’s product range covers all forms of hearing loss--sensorineural, conductive and mixed. Cochlear implants treat sensorineural hearing loss where the sensory hairs within the cochlea, or inner ear, aren’t functioning and it translates sound into a digital format and stimulates the auditory nerve directly. If the auditory nerve itself is not functioning, Cochlear has a brain stem implant device to transmit the sounds.

Bone-anchored hearing aids from its acoustics segment treat conductive hearing loss where there is a “blockage” in the outer or middle ear, which prevents sound from reaching the cochlea. Digital sounds are not necessarily a direct representation of normal hearing and patients follow a rehabilitation process for hearing restoration.

Threats to Cochlear’s wide moat come from hearing aid advancements as well as stem-cell and gene therapies. Advances in hearing aids are resulting in increasing penetration into the severe hearing loss range, defined between 71 and 90 decibels. But because hearing aids only amplify ambient noise, they are unable to treat hearing loss, particularly sensorineural hearing loss, as effectively. We don’t anticipate hearing aids will make significant inroads into the core cochlear implant profound hearing loss market.

There is currently preclinical testing of stem cell therapy and gene therapy to regenerate the hair cells in the inner ear and Cochlear is involved in testing an implant, which releases a gene therapy into the cochlea to do this. The time frame from preclinical testing to commercialized product for implanted medical devices is well over 10 years and the likelihood of approval from preclinical testing is under 10%.

In addition, the high cost of currently approved gene therapies treating other medical conditions prohibits widespread adoption. For example, an approved gene therapy in the U.S. that treats an inherited retinal disease has a list price of $850,000 US for both eyes in comparison to a cochlear implant of approximately $21,000 US in developed markets. As such, we don’t view gene therapies as a significant threat to the well-established cochlear implant market in the foreseeable future and we note Cochlear itself is also investing in R&D in this area.