Overview: record financial results

What a great year for all the stakeholders in Cochlear! From the over 22,000 new recipients of our implants, the over 100,000 cumulative recipients through to the 1,100 employees and almost 20,000 of shareholders, F06 was a truly outstanding year.

Total revenue for the year increased 30% to a record $452.3 million (compared to $349.0 million in F05). This increase in sales was driven by both an increase in cochlear implant revenues (up 24%), and full year contribution from Baha and Vistafix product lines acquired in March 2005 ($51.7 million in F06 compared to $14.8 million in F05 which represented four months of sales). Offsetting increases in cochlear implant and Baha revenues was a 23% reduction in gains from foreign exchange contracts (used to hedge our regional net cash flow) from $26.8 million last year to $20.7 million in F06.

NPAT of $80.0 million increased 34% over F05 reported numbers restated using AIFRS. This is the first year of reporting the financial statements to AIFRS rather than previous Australian Generally Accepted Accounting Principles (previous GAAP) and there are significant differences between the two sets of accounting standards. Importantly, a table reconciling the differences between AIFRS and previous GAAP for F05 appears at the end of the notes to the financial statements.

As discussed last year, given the change to AIFRS, one of our key management metrics is core earnings defined as NPAT assuming all research and development is expensed, and excluding both acquired intangible assets amortisation and share based compensation charges. Core earnings were $86.4 million for F06, 8% ahead of our previously stated core earnings profit guidance and up 42% on an AIFRS-restated F05. Core earnings is a better reflection of the after-tax cash earnings of the business, a fundamental driver of creating shareholder value (total shareholder return (TSR) for F06 was 42%).

All regions contributed to growth

All regions contributed to growth with the standout regions being Americas (sales revenue up 50% in constant currency (CC), that is fixed exchange rates), followed by Europe (up 35% in CC). Asia Pacific was up 7% in CC. While the Asia Pacific growth is below our long-term target, it was an outstanding year in terms of our largest market in Asia Pacific, namely China. We received an order for almost 15,000 cochlear implants for China for delivery over six years, an order worth approximately $270 million – with the first shipment in July 2006. With the first China donation shipment not being until July, F06 sales were impacted as China represents such a large proportion of Asia Pacific sales and there was a substantial slow down of sales in China ahead of the expected donation.

Nucleus Freedom Cochlear implant system: setting new performance benchmarks

The 24% increase in cochlear implant revenues was underpinned by a 19% increase in cochlear implant unit sales to a record 12,901 units for F06. A favourable country mix and the effect of increasing our direct distribution in certain European countries and Japan, drove the revenue increase at a higher rate than unit sales increase.

In the last quarter of F05, we launched the next generation Cochlear implant: Nucleus Freedom, and this rollout around the world was a major activity for F06.

There are a number of very important characteristics of this system: first, the clinical results our recipients are demonstrating are significantly better than any previous cochlear implant system. In a carefully designed multi-centre clinical trial involving over 50 adults, hearing performance at three months was ahead of what was previously seen at six months. Improvement continued with six months performance well ahead of three months. Importantly, substantial improvements have continued into 12 months!! In addition, the Nucleus Freedom has a powerful ASIC in the external speech processor allowing the pre-processing of the sound which helps particularly in difficult listening environments (for example, when listening to speech in noisy environments). With Nucleus Freedom, the hearing performance being demonstrated in a range of real life listening situations is truly stunning and setting new performance benchmarks.

A second key characteristic of the system is its reliability. Nucleus Freedom is the most reliable cochlear implant ever, and continues Cochlear’s tradition that every generation of implant (now five generations) has been more reliable than the previous one. Reliability is a science, not an art. Our implant reliability is based on decades of building on previous expertise and experience. For example, our “feedthroughs”, the basis of the implant being hermetic (or “airtight”), have been built in-house since the very first implant in 1982, truly a core competency and indeed a source of competitive advantage.

Third, Nucleus Freedom involves a technology platform whereby we can add various accessories and other features making the device convenient for the widest range of lifestyles and needs. For example, in F07 we are releasing a rechargeable battery option, a smaller battery pack option, as well as a backwards compatible Freedom processor for the recipients of the previous generation of Cochlear implant (N24 implant). Later, we will be able to release a version of the Nucleus Freedom speech processor for the very early implants (N22). Upgrades for existing recipients are part of our life-long commitment to our recipients as well as an important source of revenue for the business.

Baha: successful integration of the Entific Medical Systems acquisition

In March 2005, we acquired the Swedish company Entific Medical Systems for $176.3 million (enterprise value), and so F06 was the first full year of owning this business. The products include the Baha and Vistafix product lines. The Baha is a bone anchored hearing implant for conductive hearing loss or for single sided deafness and Vistafix is for anchoring certain prostheses. Importantly, Baha is complementary to cochlear implants – being indicated for different types of hearing loss. We created a new division (Bone Anchored Solutions) and integrated most of our customer support activities around the world, providing further scale in sales, marketing and clinical support for our implantable devices. Sales in F06 were $51.7 million, 30% over F05 sales (that is, assuming we had owned the business for all of F05). We have substantially increased research and development for the Baha products and remain very positive about the opportunities for bone conduction.

Research and development: our lifeblood

We remain committed to advancing the field of implantable devices for the hearing impaired and in F06 spent $56.7 million or 12% of revenues on research and development prior to capitalising and amortising development expenditure and after deducting the minority interest share. Activities cover many aspects of existing product areas as well as new product areas (for example, cochlear implants that combine electrical and acoustic stimulation for people with low frequency residual hearing) and progress on DACS (direct acoustic cochlear stimulator) – the product being developed jointly with Phonak. Technologic innovation remains a key driver as evidenced by the success of Nucleus Freedom.

Manufacturing and global supply chain upgrade

We are more than 12 months through a 30 month program to substantially upgrade manufacturing. This involves introducing “lean” concepts, training and up-skilling people and introducing major process changes in at least three areas. The process changes involve major research and development efforts to redesign the product for new manufacturing processes. This has the benefit of building scale and capacity and is critical for our future growth. Importantly, we are also completely redesigning the global supply chain. This involves everything from new warehouses in our three regions (Americas, Europe and Asia Pacific) to new people and processes that can support a growing company. We have made significant progress in building Cochlear’s internal capability to match the growth potential of the business.

Outlook:

We are positioning Cochlear for sustainable growth. There is a huge unmet clinical need for our products; for example, we are implanting less than 10% of the new people we could help each year (incidence). Clinical outcomes are improving not just from better technology (for example, Nucleus Freedom) but also different ways of using the product (for example, younger age at implantation, and bilateral implantation). The clinical outcomes today are different from even a few years ago. Most importantly, our implants are very cost effective in health economic terms. All in all, we have an opportunity to continue building this business over the long term. For F07, we anticipate core earnings of $100 million.

Our people: passion abounds

The passion in Cochlear’s workforce is palpable. The dedication and positive spirit of people to effect change and drive this business for the benefit of all, are outstanding. I would like to thank all our employees for their individual and team efforts in making F06 such a success. Together, we can continue to change the world.