Value.able: Why Cochlear looks cheap
Cochlear is one of the highest-quality companies listed on the ASX today. This week the recall of its flagship hearing device resulted in the subsequent slashing of the company’s share price, by almost 30 per cent in three days. Remember, during the GFC Cochlear shares fell from $78 to $44. In 2021 we won’t be thinking about this recent recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. So are Cochlear’s glory days over, or is it oversold? Will the recall inflict permanent scars? Roger Montgomery’s guess is that it will not. Indeed, the sell-down could be a dream come true for value investors. Read Roger’s article at www.eurekareport.com.au.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Scott P
:
Hi Darren
the reason you wouldn’t have bought at $70 is you would have been buying at a large premium to IV.
We are taught to buy at a discount to IV – how big that discount is depends on your individual view as to the risks involved/future prospects etc. You might only require a 10% MOS for an A1 consumer staple company, whereas you might look for 25% with a B1 mining company.
I think one of the main reasons people are starting to buy COH is it is now at a discount (albeit a small one) when it has traditionally traded at a large premium, & we know this is an extraordinary business.
Darren78
:
Thanks Scott, this was basically the explanation I was looking for.
However, by my calculations COH was still above 2012 IV when I saw comments about people starting to buy. This is why I was questioning people’s motives, however I have since calmed down a bit :) I realise everyone gets different estimates of IV based on their own investing requirements.
It would still be great to get COH with a MOS > 20% though! But I’ll have to be willing to miss out altogether whilst waiting for that possibility.
It’s dropped below $50 today and no sign of the market bouncing back yet.
Jason
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A danger I find with investing that I have eventually overcome is being told by media / analysts what a good company is and internally stereotyping it as so. Analysts will continue to advise what company is a ‘portfolio company’ but never talk about value. COH, for example, has been pumped as a must have for years, but if you bought coh ten years ago you’d have a total return of about 5%p.a. Cash would have been a safer option with like return against one of the ASX’s great businesses.
For the record, basic intrinsic value ten years ago was ~1700, well below the share price of high 4000s. IV today is far closer to the current share price, but from my perspective still too high for a decent return and margin of safety. COH may have grown the business by 11% last FY, but you’re still paying a premium of nearly 9x book to get the benefit.
Jason
:
Ooops make that 6x book.
john
:
Hi Roger,
Would your new A1 service help us determine how much of our trading bank should be invested at any one time? I have noticed that you are mostly cash at the moment, so this would be an area i would find guidance extremely helpful.
Thanks in advance.
Mark
:
COH is up nearly 5% today when the market is down nearly 1.6.%.
One word: Value.
Darren78
:
Whilst you might be excited about that one day gain, it has nothing to do with value. Stocks that earn no profit at all have gone up much more than that in one day and they are essentially worth northing (they are not generating a return on equity).
Peter M (Mully)
:
An updated analyst forecast I’ve been looking at suggests th.e following:
FY12 and FY13 NPAT forecasts reduced by nearly 20% to reflect loss of market share and softer pricing.
Inventory write off, business interruption and refund impacts treated as below the line non recurring items.
DPS forecasts reduced quite substantially given likely cash requirements to pay for refunds.
Impacts on their valuation include:
– write off of inventory
– refunds
– loss of sales whilst manufacture and supply chain is reorganized to to increase supply of alternative implant.
– one month loss of sales in FY12
– 5% loss of market share
Combined impact of the above on their valuation is circa $940m which has been further discounted by 10% to account for imprecision in their assumptions.
Revised NPAT, EPS & DPS as follows:
2012
NPAT = $162.5m
EPS = 278.1c
DPS = 0.60c
2013
NPAT = $189.5m
EPS = 323.1c
DPS = 150.0c
Whilst I hope this info is of some assistance, it should not be relied upon and is not a substitute for undertaking your own research.
Darren78
:
Thanks for that, it will still be interesting to see what the company announces to the market.
Ray H
:
COH is certainly cheaper, but that does not mean it is cheap. It is still trading well above what I regard as intrinsic value so it will have to be sold off further before I will pay much attention.
Vishal Hargovan
:
Hi Roger,
COH does not appear to be at a discount to the as yet unknown IV (using the UBS forecast). It may well be at a discount to future IV but given the risks perhaps not a large enough discount based on strict adherence to the value.able methodology. Does this imply a degree of speculation? My question is have you deviated from strict adherence to rules for buying presented in value.able and if so what are the circumstances which will cause you to do so? I suspect your superior level of value investing experience and also an in depth knowledge of the COH business have something to do with it?
Regards,
Vishal
Roger Montgomery
:
Hi Vishal,
Our scenario analysis produces a trigger to start an accumulation process. You say ‘unknown’ intrinsic value. All intrinsic values are unknown. They are estimates. Our process of accumulation begins when certain criteria are met and accelerates when other criteria are met but they are our 11 secret herbs and spices so thanks for the question.
Ian
:
After the Nucleus CI500 range, Cochlear’s previous models the Nucleus Freedom would have to be regarded by most as the gold standard in Cochlear implants. I would expect that after the recall many doctors would still recommend to their patients to use the previous Cochlear model rather than a competitors product. If I could find confirmation that this is what most doctors are doing and that Cochlear can quickly get sufficient stock of the previous model out into the market then I would be ready to buy the stock at around the current price.
There will be a short term cost and some loss of sales, but hopfully the majority of people needing an implant will continue to choose a cochlear product, so limiting the loss of sales in he short term and hopefully a bright future for cochlear in the long term as I still regard them as having the best product on the market and should be able to maintain this advantage with their R&D spend.
Roger Montgomery
:
With a gun to my head and forced to make a bet this very second, I am inclined to agree with you.
Michael
:
Roger
Given the generally bearish conditions right now, perhaps this might be a good time to ask you what percentage of all the stocks you track are presently trading below intrinsic value?
Michael
Roger Montgomery
:
Hi Michael,
Taking the A1s as a cohort – of which there are only 30 following the reporting season – ten are exhibiting some margin of safety. Of course out of those ten, there are those who intrinsic values aren’t rising at an attractive rate or the margin of safety is in the single digits.
Darren78
:
Hi, I don’t have a subscription so didn’t read the Eureka writeup, apologies if my questions were addressed in the article.
Before the product recall I had a 2012 value of $57.20.
Now with the impact of the recall, I have a value of around $42 for 2012.
I reduced expected NPAT for 2012 from $193m to $170m to account for the costs of the recall and loss of revenue. But this is just a guestimate based on some newspaper articles (some were predicting NPAT as low as $100m for 2012).
So I am wondering all the people who say they’ve just bought in after the drop, did they re-value for 2012? It seems like people are operating under the same valuation and believe they are getting a discount.
Or do people ignore the short term losses attributable to the recall and are looking further out from 2012? Because it’s such a quality company?
With my current valuations, I would be waiting to see if it gets to $40. Am I being too cautious?
PS. I previously held this stock at $71…selling out at $80 (when I realised i had bought badly after reading value.able)…got lucky then, don’t want to rely on luck this time.
Roger Montgomery
:
Hi Darren,
YOu have to still calculate the value for this year and the future. The reality is that all future valuations shift out further by years because the new equity/BV figure will be lower than previously expected.
Vishal Hargovan
:
Hi Roger,
How do we know COH is cheap right now if we dont know the financial impacts of the recall? Is this speculation? I understand the quality of COH, its superior record over many years and also that its future prospects remain bright. However until we know that we are getting it at a discount to intrinsic value is it sensible to get in now? There is obviously more to it than buying at a discount to current IV (and future IV), but I would like to know if you have exercised some judgement here rather than strict adherance to the value.able methodology for when to buy.
Regards,
Vishal
Roger Montgomery
:
Scenario analysis Vishal. Whats the worst case scenario of 2012 – a $400 million revenue hole (this product produced c50% of revenue). OK then. How many years before their R&D gets it back on the shelf or produces a new and superior product? In the meantime how much market share can a competitor take take back when they have not only had their own recalls but their products have caused electric shocks to patients? As Chalrie Munger noted, he’s a better investor because his “guesses” are better than most.
Vishal Hargovan
:
Thanks Roger,
You are very kind to share your insights with myself and fellow bloggers. Tools such a scenario analysis are extremely useful in the credit risk area of a bank (where I work) but clearly they can also be used to understand businesses and their sensitivity to various inputs.
Regards, Vishal
Darren78
:
Hey Roger,
Yes, I understand that, I have re-done my calculations for 2012 and 2013.
My question is why do you say it’s cheap when I don’t see a MOS except if I start looking past 2012. Obviously I am lacking what you’ve said in the Eureka aritcle.
Eg. 2013 IV is $56.86
Which means if I bought now at $50 that would only be a ~12% discount and we are taught to look for >20% discount.
I am thinking that people are buying with no MOS right now simply because they’ve waited so long for the price to get to a resonable level. They are sacrificing MOS just to get into a quality company.
Unless someone can tell me something different, I’ll be holding out to see if it drops to the low $40’s. (and believe me I am tempted to get in now, but I want to stick to strict value.able investing methods).
Roger Montgomery
:
We have purchased a very small amount of the total position we would typically have for a company with these caharacteristics and will now engage our accumulation process – which will benefit if prices continue to fall. Our 10/10 rule and 20/20 rule ensure we only make significant investments in the scenarios that meet all our criteria.
Greg Mc
:
The old line about buying a wonderful company at a fair price is better than a fair company at a wonderful price rings a bell here, Darren.
Simon Anthony
:
“They are sacrificing MOS just to get into a quality company.” Think about that statement and whether a 17% growth year on year would allow you to open a position if MOS was 0%. If the answer is no then you can wait for the price to retract further and a greater MOS to appear. Or you can wait until the directors announce the known financial impact of the recall. By that time you may have to purchase COH in the $60-$70 range, as other Value investors have been accumulating shares earlier at much lower prices. You’ll pay a premium price for peace of mind in this bear market.
Matthew R
:
Buffett once said that buying Coca-Cola wasn’t necessarily about the discount. He bought based on the quality of the business. Buffett: “If you gave me $100 billion and said, ‘Take away the soft-drink leadership of Coca-Cola in the world,’ I’d give it back to you and say it can’t be done.”
Under the guidance of Munger Berkshire increasingly ‘preferred to purchase a wonderful business at a fair price’. They learnt that after buying See’s and it has worked out pretty well for them.
COH is an example of a wonderful business in my opinion, at a fair price. I bought a part position at $52 and would like to buy more if it gets lower. I have the room to do so. I hope you are right and it goes to $40! But if not, I have a foot in a wonderful door.
Matthew R
:
I would like to pose a question – if you had $3B up your sleeve would you go and buy all of Cochlear with the view to owning it forever?
I think I would seriously consider it
What is one or two years of decreased profits? What if they make a profit of $0 next year, and the year after? Would that really make much difference if you plan to hold the company for 100 years?
The question becomes, can their competitive advantage withstand this shock?
Darren78
:
Thanks for everyones comments.
I thought the rule “buy with a large discount to intrinsic value” applied to all quality companies, not just picking and choosing which companies you will apply it to.
If you decided to bend or deny this rule, then why not buy COH at $70? You could reason in 5 years it will be worth alot more.
If there are exceptions to the rule of purchasing with a large discount, then I think that should be discussed. After all, quality is really important but you’re not likely to see much of a return soon if you overpay for it…right??
Greg Mc
:
That’s correct Darren. There is somewhat of a difference between buying around IV and buying 30% above it mind you. If you buy at IV, your long term return will be roughly the rate of increase in value of the business. I certainly do buy at different discounts to (what I think is) IV depending on the company. COH at a minor discount I will take, but it is a rare exception.
AndyC
:
I think that’s a great point to highlight Darren.
I bought some yesterday, but I agree there’s still potential for the intrinsic value to suffer depending on how things play out.
If I’m honest with myself, I think there’s some element of betting that the company will pull through based on various aspects of quality.
We should anchor ourselves to both quality and value. This one is a tricky one to balance.
Roger Montgomery
:
Whats the worst case scenario of 2012 – a $400 million revenue hole (50% of rev this product). OK then. How many years before their R&D gets it back on the shelf or produces a new and superior product? In the meantime how much market share can a competitor take take back when they have not only had their own recalls but their products have caused electric shocks to patients? As Chalrie Munger noted, he’s a better investor because his “guesses” are better than most.
Andyc
:
Good points Roger, I agree with your view. There needs to be some element of intuition (“guesses”) when looking for truly great investments, otherwise investing would be easy. I’m glad that it’s hard to balance these negative situations, it creates opportunity.
We will always be able to conjure up hopeful outlooks for mediocre companies, and pessimistic outlooks for super businesses. Ultimately, we will make money if our reasoning is right. This reasoning includes more than valuation in my humble view.