Don't be fooled by the recent dip in share price, hearing device maker Cochlear Limited (ASX: COH) is in great shape.
The company is expected to announce a full year profit of between $210m and $225m when it reports later this month, growth of 10-20%.
One giant reason to buy
One of the things I like most about Cochlear is its huge return on equity (ROE) which completely blows away the 10% average for U.S. healthcare product companies.
Return on equity shows us how effectively a company is using investor funds. Cochlear is among the best-in-class when it comes to the ROE measure, just short of CSL Limited (ASX: CSL).
Here's how Cochlear's ROE has tracked over the last five years:
| Cochlear Limited | 2016 | 2015 | 2014 | 2013 | 2012 |
| Net Income ($m) | 189 | 146 | 94 | 133 | 57 |
| Total equity ($m) | 449 | 355 | 329 | 355 | 385 |
| ROE | 42% | 41% | 29% | 38% | 15% |
Source: Cochlear Limited annual reports
It's worth pointing out that I haven't made any adjustments to reported net income. In 2012 for example net income includes a one-time $101 million cost associated with product recalls.
It's also interesting to see the significant increase in equity reported in 2016. This was in part because Cochlear's higher earnings left it with more retained earnings.
Breaking down return on equity
To see where Cochlear's huge 42% ROE comes from we can break it out into three components using the DuPont analysis:
- Net profit margin (Net Income ÷ Revenue) 0.17
- Asset Turnover (Revenue ÷ Assets) 1.18
- Equity Multiplier (Assets ÷ Shareholders' Equity) 2.13
- Return on equity = (0.17) x (1.18) x (2.13) = 42.1%
We can quickly see that a big driver of the returns is Cochlear's use of debt to fund assets; the high equity multiplier. Without this, if Cochlear didn't leverage its assets with borrowed money, ROE would only be 19.7%.
That would still be a pretty good return! And because Cochlear has strong cash flows to service the interest I would not be concerned by current debt levels.
However if a comparable investment had a higher unleveraged return, for example Fisher & Paykel Healthcare Corp Ltd (ASX: FPH), we may prefer to buy it.
Foolish takeaway
Cochlear's business focuses on all the right areas to deliver strong returns for investors. Quality products drive strong profit margins, high volumes accelerate the turnover of assets and reasonable use of debt leverages returns upwards.
This is a company I would love to own, and I will certainly be watching for any further weakness in share price.
