Nov 18, 2020 in Analysis
Business Valuation and Financial Analysis

Background

The company under study has been renowned as the worlds leader in the ear implant segment while trading under the two broad categories as Cochlear (Nucleus, Kanso, etc.) and Baha. It has been reported that the potential market is largely comprised of the disabled versus elderly strata accounting for some 5% of the total and one-third of the age group, respectively. Over the 2013-2014 time period, the market saw hybrid solutions acting to fine-tune the Nucleus sound processor to multiple applications, albeit amidst a major 35.71% decrease in procurements to China. In fact, this circumstance will be acted upon in casting further projections. At this stage, suffice it to point out how the notion of shared future could fit just squarely into either the enterprise of creating shared value or otherwise positioning own socially responsive stance as a reason to penetrate the would-be host markets.

 

Prospective Analysis

Forecasting

Cochlear has gone through some turbulent times that marked the post-recession transition in the rest of its OECD markets other than Australia. Although the latter has boasted an enviable as well as sustained GDP growth performance, the exports stagnated well into 2013. On the other hand, the structural breakdown of its core markets has remained fairly stable throughout, and can at this stage be drawn upon in arriving at plausible sales scenarios with an eye toward the emerging markets, notably the neighbouring ones.

To begin with, China has remained Australias single largest trading and FDI partner over the past decade, boasting a GDP level comparable to that of the US in PPP (purchasing power parity terms) starting from 2015. That said, despite steady growth as well as occasional currency interventions that have been aimed at striking a balance of keeping the renminbi stable yet weak enough to secure an exports edge, the Chinese planning and monetary authorities have not been able to prevent the economy from decelerating. Worse yet, because of a major sag in the official reserves as aimed at softening last years stock market downturn, the state-controlled investment outlays might not be as large as they have been thus farand the same holds for capital rationing at the government-market partnership end.

In other words, it is this second-order growth slowing that embeds some pessimism into the otherwise promising outlook for Cochlear to tap into unfilled and fast-growing markets. However, it should be pointed out that convergence is underway in terms of long-term trends looming large in areas as diverse as, the demographic shifts, skewed preference distribution, and R&D synergy that might facilitate scale efficiency and knowledge spill-over with reference to asset non-specificity that does not border on inappropriability or ease of mimicking. The latter two issues are coupled with how incremental costs as well as human capital can be shared within implied value chains where TQM can be ensured rather than outsourced or delegatedbearing in mind that the primary customers are not price shoppers in that they tend to stress value over savings. In a sense, they are too risk-averse to be on the look-out for substitutes, which amounts to value shopping beyond price or income elasticity. For that matter, the demographic dimension seconds this propensity, in that the demand for the core product and solution selling or complements will likely grow as the proportion of the elderly increases.

It will be shown how the sales growth forecast builds on the demographic shifts and the market expasion or reshuffling to account for the 2% lower and 4.33% upper bound estimates, with the conservative or weighted-average resulting in a 2.93% growth rate. As per the WACC part, it will draw on a beta of .63 and a CAPM cost of equity which builds upon an AUX market index growth rate of 7% and a T-bond mid-term yield at 2.2% to be used as the risk-free rate. After all, the market for Treasuries is ample and liquid enough for investors (at least institutional) to readily tap into a risk-free opportunitywhich rationale does not carry over to either the less liquid government or corporate bonds. It is moreover presumed that WACC cannot always be seen as the risk-free equivalent in a reversed setup, if only because otherwise the weights might be abnormal (one being negative and the other above unity), should the resultant WACC acting as risk-free be assumed below either of these components. Finally, the cost of debt is taken as Cochlears historical average a5 4.04%, or 2.83% in after-tax terms.

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Valuations

It is at this stage that the competing trends and structural implications can be reconciled in a parsimonious as well as consistent fashion. For instance, based on the regional sales structure whereby the North America versus Asian Pacific rim have accounted for 43% and 17% of the demand respectively, one could safely presume that Chinas market might alone reveal a capacity measuring up to Americas effective demand. Although this is based on the comparable GDP levels yet not their per-capita counterparts, still convergence is in sight over the long haulwhich should accommodate the sales projections. One way to proceed would be to spread the increment over a five to six years time span as follows:

  • However, this only posits the optimistic scenario, with the pessimistic lower-bound assumed at 2% per annum referring to the aging effect that might suffice alone. In actuality, the conservative toss-up could be chosen in between the corner cases as a weighted average subject to a particular level of interim or long-term optimism. In fact, this has very little to do with indices measuring consumer moods or investor sentiments. In the short run, it might correlate with the stages of the real business cycle. Overall, the optimism weight will pertain to company-specific outlook, as a likely success to implement a strategy to be addressed in the next section, as well as on the strength of its leadership in retrospect. The conservative growth rate could be imputed as,
  • Although this weighting has been assumed at .4 (in light of the OECD demand having been saturated and emerging markets being too disparate to aggregate with certainty), it will not affect the two corner cases as per the sensitivity analysis.
  • The WACC owes its cost-of-equity component to a CAPM beta estimated at .63. The rest of the applicable input values have been scrutinised so as to look at history as but one of the concerns. For instance, it has been observed that 2014 marked a recovery in the sales growth, with a high enough rate being largely a matter of mean-reversion vis-a-vis the previously depressed denominator hurdle. Since a 6.94% revenue growth appears better than the optimistic-scenario estimate, the ATO and PM have been adjusted accordingly based on the historic average times the respective growth comparison gapwith, say, a PM of 24% hovering in between the optimistic versus conservative comparison against the said rate.
  • With these in mind, and a dividend payout ratio below the historic low at 20%, the resultant NPV per share totals AUD143, which is slightly in excess of the trailing average or last reported price of AUD138.08. This suggests a strong HOLD decision. Further sensitivity analysis is to reveal whether there is any upside slack qualifying the stock as a BUY. More importantly, the degrees of freedom in question (i.e. ATO, PM, WACC, and sales growth) should suffice to single out areas of either utter, knife-edge instability or of invariance.
  • Along these lines, it is noteworthy that the proposed value per share is an average over the four alternate models whose individual valuation outcomes are more widely distributed than that (Table 1). Once a 45% dividend payout rate has been attempted (which appears in line with the historical mode as well as Cochlear likely turning into a cash cow), the average price totals AUD157.02 all else held the same, up from the previous AUD143, even though it is the DDM and RIM approaches that exhibit excessive sensitivity to this parameter. With the ROIM feeding out a high $219.63, a BUY recommendation ensues.

Sensitivity Analysis: Parametric Assumptions & Outcomes

Other than that, the sensitivity analysis can be conducted in sequential, incremental stepse.g. compared to some kind of benchmark such as the one proposed above, with parameters relaxed and changed gradually. Table 2A showcases the big picture, suggesting among other things that a fair average value very close to the last reported price at AUD138.18 obtains as a cross-over for a conservative growth scenario comparable to the benchmark save for a higher WACC at 5.22% (since it has not been relaxed as yet) as well as ATO of 1.05 rather than .88. This posits a trade-off across a set of parameters, in addition to stand-alone manipulation.

It should be noted that the last value in the optimistic corner has shown to be negative, as a degenerate case due to the overly high expected growth rate exceeding the WACC discount. It has been contributed by the ROIM part whose TV component is by design discounted as a growing, Gordon-style perpetuity (and the same holds for the free cash flow model). Otherwise, the sensitivity pattern does not prove to be very monotonous, though. Whereas complete relaxation, or alteration of each parameter between the pessimistic versus conservative corners, yields twice as high a value (AUD162.25 versus AUD81.54), this pattern is marginally reversed at the outset, i.e. at a minimum alteration (AUD107.35 versus AUD111.16). By contrast, anywhere near the optimistic corner, a major increment in each parameter causes an explosive or disproportionate change of the same expected sign.

Interestingly enough, Table 2B proposes a more compressed, ROIM-only perspective with the target price hitting an AUD 152.41 to AUD 171.17 and a pessimistic growth still accommodating a strong HOLD. Overall, the conservative versus optimistic scenarios co-move, amid the pessimistic corner proving inverted. Whereas a low 20% PM in the latter case draws the SELL divide, the strong BUY decision only gets out of control in the event of a very high growth, with a negative valuation being a singular instance of growth having to be accounted for by means other than a WACC differential.

Applications & Recommendations

Cochlear may well see a bullish phase early on, as the latter lends itself well with the near-optimistic input values. However, this stage will likely be short-lived, which is to suggest longer-term sensitivity analysis may have to be aligned with the analysis of variances (as part and parcel of budgeting), so that managing-by-exceptions (MbE) could be done with respect to the more pronounced as well as controllable channels. Among other things, irrespective of the time horizon, sales growth appears to be one such candidacy, if only because the rest are derivative or indirect in nature (whereas WACC will vary with the changing structure of capital).

In order to foster sales growth, Cochlear should be able to embark on a full-fledged blue ocean type diversification strategy on the strength of its unique expertise in biotechnology. What the latter agenda refers to is the recent breakthrough in cochlear-designed sound recognition and spectrum analysis techniques as pioneered by the MIT researchers at an unprecedented level of power efficiency. In fact, energy savings and range of applications could alone suggest every reason for Cochlear Limited to expand on its scope as well as B2B customer base. Although the bulk of the effect will likely turn out to be just thata favourable externality accruing as a public good,--this will clearly translate into instantaneous yet lasting reputation and goodwill outcomes.

In this setup, the blue ocean approach pertains to shifting the frontier of opportunity while simultaneously bypassing the differentiation-efficiency tradeoff. In fact, a near-monopoly that has long taken a rather aggressive M&A stance in order to remain a standards setter, may ironically end up restrained as per indiscriminate use of its market share or bargaining power. On the one hand, any large company would routinely want to either boost profitability by fostering differentiation or otherwise opt to maintain an adequate efficiency scale as an entry barrier fostering the cost efficiency side. On the other hand, a blue ocean strategy might come in handy whenever a mixed strategy (in game-theoretic lingo) might either not be feasible or otherwise prove inferior.

As far as Cochlear is concerned, a sheer lack of substitutes, alongside high and inelastic demand amid permanent ageing trends, might not suffice to secure ample leeway to opt for just any sales booster. It is for one restrained by its own historically high quality standards, bearing in mind that the OECD customers will hardly settle for anything less than the best out there. The flip-side, though, might be the ongoing, incremental or project-specific R&D outlays the company has been forced to incur in order to keep up with its own differentiation legacy. Needless to say, this will exert dramatic pressure on the cash flows unless shared within a broader value chain along the proposed lines.

Cochlear may have to embark on a major value divergence as opposed to minor yet costly differentiation or non-organic M&A expansion, if it is to scale up its growth prospects within its mature core markets, with the aging trends only competing against the success of alternate medical solutions, notably antibiotics treating otitis. On the other hand, the company may well want to diversify onto the LDC or emerging markets, notably Africa and Latin America, with low-cost solutions clearly favoured over full-fledged functionality. At this rate, the company could still establish itself as a good corporate citizen while making use of the blue-ocean modality of tapping a non-customer base of those not having been exposed to solutions for any preferences to have emerged in the first place.

One final consideration pertains to how closely all of the alternate model values can converge in the event of either a minimal gap between the scenarios in question or a material deviation between the WACC and the growth component of the discount factor. In addition to narrowing the valuation and strategy leeway, however, this might not stand up to scrutiny.

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