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At the close of trading on Friday 09 September shares of the world’s largest hearing implant manufacturer Cochlear sat at a lofty $72 and change.  The volume for the day was 153 thousand shares.

On Monday 12 September the company announced a voluntary recall of its flagship product and the shares closed the day at $57.5, with volume at 2,676 million shares changing hands.

Here is how the respected Dow Jones Newswires reported the news that sparked the massive sell-off:

•    MELBOURNE (Dow Jones)-Hearing implant maker Cochlear Ltd. (COH.AU) said Monday it is undertaking a voluntary recall of its unimplanted Nucleus CI500 range after a recent increase in failures in its Nucleus CI512 implants.

•    However, it noted that less than 1% of the Nucleus CI512 implants have failed since launch in 2009.

•    “In an abundance of caution, Cochlear has issued a voluntary recall of the Nucleus CI500 range of cochlear implants while it further investigates the cause of this issue,” the company said in a statement.

•    It said the financial impact of the recall is difficult to predict at this stage.

When a stellar share performer like COH takes a 20% fall in a single day, investors of all stripes take notice.  While analysts rush to modify their earnings and other estimates, shorts gather to see if there is an opportunity for continued downward slide and value investors start sniffing around for a potential bargain.

As you probably know, many a novice investor has learned the hard way that a “can’t miss” buying opportunity ends up being no more than a falling knife as the shares continue to plunge.  So how does one differentiate between a buying opportunity and a falling knife?

There are no easy answers but one thing is for sure.  You should not rely solely on initial press releases and analyst opinions.  The Cochlear recall story provides an excellent case study example.

First, few intelligent investors would make a buying decision based on a press release like the one we highlighted above.  A one percent failure rate of a product line introduced in 2009 doesn’t sound like it warrants the massive sell-off.  But then there is the troubling word in the press release – recent.

Digging deeper we learn the failure rate since February 2010 stands at a more alarming 42%.  What’s worse, 60% of that increase has come within the last 6 months.  Few press releases and fewer analysts highlighted this point.

In short, even investors unfamiliar with Cochlear in particular or the industry in general can see this recall poses problems for Cochlear in terms of earnings potential, market share, and reputation.

In essence, the intelligent investor must answer two questions:

1.    How bad will the impact be; and

2.    What is the company’s capacity to rebound?

History gives us some clues to an answer for question #2.  Here is a five year share price chart for COH going back to the onset of the GFC:

Cochlear survived the GFC and as you can see at the end of 2010 and through the first months of 2011 was trading above its pre-GFC share price.  

A year over year comparison of the company’s performance on measures relevant to its ability to survive a decline in sales from this recall will help fill in the picture.  Here is a five year table of Cochlear’s performance on net profit after taxes, net gearing ratio, and long term debt.

Year over Year Comparison

 6/076/086/096/106/11
Net Profit After Tax100.1 $m115.2 $m130.5 $m155 $m180 $m
Net Operating Cash Flow76.84 $m84.55 $m146.63 $m179.55 $m201.28 $m
Long – Term Debt37.6 $m154.5 $m188.6 $m83 $m3 $m
Net Gearing 44.3 %41.7 %29.8 %26 %-1.9 %

 

Both net profit and cash flow from operations have increased every year.  Long term debt in 2011 is at what might be a record low for the company.  Gearing has decreased every year for the past five years.  In short, their financial condition is strong and puts them in a good position to withstand a decline in revenue due to the recall.

To address the question of how badly the recall will impact COH earnings, we begin with some analyst opinions.  Most financial analysts are well-trained and very knowledgeable when it comes to the companies they cover; but in truth, their estimates in a situation like this are at best, educated guesses.

In the world of hard sciences you would expect a variety of experts to view data and come up with similar conclusions.  With Cochlear, analysts are all over the map.  

First, no one can predict with any accuracy how much damage this will do to Cochlear’s reputation.  The company has never had a recall before.  One of their competitors – Advanced Bionics – had a recent recall of a similar product where customers experienced pain from a malfunction involving loud sounds.  In Cochlear’s case, the stgices simply stopped functioning and no one was injured.

Second, the earnings revision picture is confusing to say the least.  Cochlear has an alternative product to offer for new implants.  The recall was only for products yet to be implanted, with existing failures being corrected with parts replacements.  This of course raises the question of what happens if already implanted stgices continue to fail.

UBS sees a limited financial impact from the recall since the removal of the competitive Advanced Bionics product from the market leaves physicians with few, if any, viable alternatives.

Goldman Sachs, on the other hand, is cutting earnings forecasts by 30% to 40% and warning of lower margins.  They have placed a sell recommendation on the shares.

RBS Australia is a bit more optimistic, estimating an earnings drop of 15%.  The consensus price target among analysts covering the shares has dropped to $59, down from a $72 target price right before the recall.

Some decisive investors with a high tolerance for risk may have looked at the new P/E ratio and jumped right in.  Thompson Reuters reports a forward P/E ratio of a mere 16.21.  Cochlear’s P/E ratio over the last 5 years has ranged from a high of 33.86 to a low of 21.13.

You probably already know the end of this tale, but let us look at a one month price chart of COH to see what happened to those who bought in immediately after the recall:

#FOTO:1303:400#

You can see the share price began to recover and then took another steep drop.  In a case of terrible timing, on 13 September Advanced Bionics announced their product had gotten FDA approval to re-enter the United States market.

Ultimately the answer to whether or not COH is now a buying opportunity or a falling knife comes down to your investment philosophy.  With an investing time frame of 5 years or more, the chances of Cochlear returning to prior share price highs is good.  They still are the recognised leader in the industry and with their investment of an impressive 12% of sales revenue into research and stgelopment; they should be able to maintain their market-leading position.

However, until the recall issue is fully behind them, short term investors should be aware the knife still may have more room to fall. 

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