Cochlear (ASX: COH) shares took a step back this week following an underwhelming full year profit report. While the business continues to grow, the market expected more, and some scale back of FY16 expectations was required.
Having looked at Cochlear recently, we think that it may be a victim of its own success. For several decades, Cochlear has shown very strong growth and exceptional economics. Shareholders have done very well over this time, and Cochlear holds a special place in the hearts of many.
The problem, is that good things eventually run their course, and there are clear signs that the future will be significantly more challenging for Cochlear. The key reasons for this include:
- Market growth has historically been very strong. However, over time markets for new products become saturated, and most of the countries that can afford a cochlear implant program now have them. This, combined with some other factors leads us to believe in a significantly slower rate of growth in future;
- In addition, the rate of technology improvement has slowed. As sentence recognition rates approach 100 per cent and failure rates approach 0 per cent, the ability to eke out further gains becomes limited. This slowdown in progress gives competitors an opportunity to catch up with Cochlear’s performance, and allows new entrants to compete with older technology that may not be cutting edge, but delivers comparable performance at a lower cost. Also, the incentive for users to upgrade to the latest product becomes less compelling;
- This competition of maturing markets and relatively stronger competition is poisonous to excess economic returns, and excess economic returns have driven Cochlear’s spectacular share price growth since its formation back in 1981.
It appears as though a lot of investors may have extrapolated Cochlear’s past growth rates many years into the future. From our perspective however, it seems very unlikely that this can be achieved, and we conclude that future earnings growth may cause further disappointment.
Hats off to Cochlear for its achievements on the global stage. It remains a high quality business with some attractive features, but its share price is not one of them.