The healthcare sector has been the source of two of Australia's greatest success stories. Cochlear and ResMed both listed in 1995. Since then, Cochlear's shares have increased twentyfold while ResMed is up a remarkable 54 times.
But Cochlear is now down 30 per cent since it hit $82.87 in January last year, while ResMed has fallen 20 per cent since peaking at $5.94 in October. Cochlear's problems stem from its product recall and reinvigorated competition. ResMed is suffering from a one-off dislocation in the United States market, with some added competition. So which stock is best?
Cochlear's bionic ear allows the profoundly deaf to hear, while ResMed ensures that patients with obstructive sleep apnoea get a good night's sleep.
These are highly profitable and growing markets, but Cochlear, with a 60 per cent market share, is more dominant in its field than ResMed, which runs neck and neck with Philips Respironics. Investors should seek out companies that are either number one or number two in their fields and, on this measure, both firms score well. But Cochlear has a better market position: there simply isn't a competitive treatment for bionic ears.
In 2013, ResMed spent 8 per cent of its revenue on research and development, while Cochlear spent 17 per cent, making it very difficult for a new entrant to break into their markets. The added complexity of Cochlear's product, which can cost tens of thousands of dollars, gives it the edge.
What about the bargaining position of the customer? Both companies depend on governments and health insurers to pay for all or part of their products, which is a major source of ResMed's recent problems. In the US, Medicare introduced competitive bidding on a range of durable medical equipment, putting pressure on prices and causing ordering delays. Cochlear is not caught up in this.
With Cochlear top in most measures, you would expect it to perform better financially and, with an average operating margin during the past five years of 27 per cent and an average return on capital of 44 per cent, against 22 per cent and 28 per cent for ResMed, it does.
But in the past five years, Cochlear has increased its earnings per share by only 2 per cent a year, while ResMed has managed 23 per cent. ResMed has greater scope to invest at this rate to lift earnings.
Cochlear's underlying earnings are hard to pin down because of its recent product launches, currency hedging and lumpy Chinese government contracts, but if it makes its guidance for the second half of 2014 and carries that into 2015, it could generate underlying earnings per share (before currency hedges) of about $2.80. That would put it on a 2015 price-earnings ratio of about 20 and, at $55, we would upgrade it to a buy, but for now: Hold.
ResMed trades at about 18 times consensus forecast for 2014. Assuming the problems caused by competitive bidding pass, this looks cheap for a firm of such high quality and growth potential. Buy.
This article contains general investment advice only (under AFSL 282288).
Nathan Bell is research director of Intelligent Investor Share Advisor. For a 15-day free membership, see shares.intelligentinvestor. com.au/smh-free-trial.
