RESEARCH NOTE. Cochlear Ltd Neutral

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1 1 RESEARCH NOTE Cochlear Ltd Neutral Price: A$ Price Target: A$ ASX: COH 3 October 2017 The Chinese government has put out a request for tender for 2891 units of Cochlear implants to be delivered in two batches (split 1,491 and 1,400 units respectively). The deadline for submission of bids is 18th of October The timing of awards for previous tender suggest a lag time of one to two months before the winning bidders are announced. Assuming, COH wins the tender, earnings will be recognised in the second half of 2018, and will add ~1 to 5% to FY18 earnings on our numbers (assuming a win at ~US$5,490 per unit, the lowest winning bid at the last tender). Whilst COH trades on a lofty 37.6x one year forward price to earnings, 1.8% dividend yield and at a premium to our price target, we believe it is warranted given its quality and sales momentum (which may surprise to the upside); Neutral. Management Expect latest Chinese tender to be immaterial kicker to earnings. At the analyst conference call following COH s August results, management highlighted we've put an estimation for China when we do our guidance. The reality of that tender now compared to the size of the business is that it's not significant from a revenue perspective. As we've said before, the Chinese government national government has committed to the five-year plan from 2016 to 2020 to continue to fund the tender at the same level as in the past, which has been sort of 4,500 to 5,000 implants a year. So we would expect them to tender that volume over the next 12 months, but we don't know when and we don't know if it'll be in tranches like it's been in the past or if it'll be all in one go like it was this year. So for us to try to put a number out

2 2 there would just be us speculating on how this tender will be run. Market estimates that 28 million deaf people in China and 30,000 babies are born with hearing problems per annum. Pricing pressure to continue for tenders, especially China; question around whether same pressures are rippling through private patients market. At the analyst conference call following COH s August results, management pointed out in tender markets, there's definitely pricing pressure. There always has been. Tenders are compared purely on price in most instances in developing markets. In developed markets, some of them we do see price pressure and we've talked about that for a while. Documents published on the website of China's Ministry of Finance for the last tender showed 4800 units were divided approximately equally COH s competitors (US-based Advanced Bionics, Austria based Med-El and Chinese newcomer Nurotron). The lowest price per unit was US$5,490 by Med-El, ~31% lower than COH s winning tender three years ago. The highest price winner was Nurotron at US$5,916 per unit. Nurotron bested COH in a tender last year, but failed to have the production capacity to fulfil the tender and so handed it back to the government, which was subsequently awarded to COH. Nurotron founder Li Fangping recently opened a Hangzhou-based factory aiming to double production this year to 6000 units. Nurotron anticipates that at full capacity, they will be able to produce 20,000 units per annum. Implant assembly remains labour intensive. With assembling of cochlear implants remaining highly labour intensive, competitors such as Chinese based Nurotron with operations in low wage jurisdictions has had a significant advantage over COH (and hence the tendering process). In July 2017, COH announced its intentions to build a $50m Chinesebased manufacturing in Chengdu, capital of China's Sichuan province. The plant will expand capacity by ~50% when it reaches its full capacity in ~7 years. Whilst COH is still in the process of obtaining regulatory approvals with the Chengdu plant not expected to be operational for at least 4 years, in our view, the strategy makes sense as (1) China is COH s fastest growing market by volume; (2) it would lower the per cost unit of production; and (3) the plant puts COH in a more competitive position, not just for tenders, but potentially in a positive slant from the perspective of the Chinese government.

3 3 Reminder on FY18 outlook from recent results briefing. Management provided the following outlook commentary (1) net profit to increase to A$ m, or ~7.6% growth. (2) Management expects a weighted average AUD/USD exchange rate of 80 cents for FY18, which will have an unfavourable impact on net profit growth. (3) Dividend payout ratio is targeted around 70% of net profit. (4) Nucleus 7 Sound Processor will be released in September, which will cause net profit to grow stronger in the second half than the first half. (5) The momentum in unit growth is expected to continue. (6) Product development and market growth initiatives expected to underpin growth in FY18. (7) R&D expenditure is expected to be $ m. Further, the recent acquisition of Sycle should add to revenue and NPAT in FY18. Investment Thesis We rate COH as a Neutral due to the following reasons: Trading on fair value (on absolute and relative basis of PE18 of 37.6x, ~1.8% dividend yield). Attractive hearing loss market with 1)~5% of world s population or 360m have disabling hearing loss (328m adults and 32m children); 2) 1 in 3 people over age of 65 affected by hearing loss; 3) less than 5% market penetration. Market leading positions globally. Direct-to-consumer marketing expected to fast track market growth. Best in class R&D program (significant dollar amount) leading to continual development of new products and upgrades to existing suite of products. New product launches expected across all categories over the next 18 months. Leveraged to the falling AUD/USD. Attractive exposure to growth in China and India. Solid balance sheet position.

4 4 Key Risks We see the following key risks to our investment thesis: Product recall. R&D program fails to deliver innovative products. Increase in competitive pressures. Change in government reimbursement policy. Adverse movements in AUD/USD. Emerging or Developed market growth disappoints. Company Description Cochlear Ltd (COH) researches, develops and markets cochlear implant systems for hearing impaired people. COH s hearing implant systems include Nucleus and Baha and are sold globally. COH has direct operations in 20 countries and 2,800 employees. FIGURE 1: COH REVENUE BY REGION

5 5 FIGURE 2: COH REVENUE BY SEGMENT FIGURE 3: COMPARABLES

6 6 FIGURE 4: COH FINANCIAL SUMMARY

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