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Edited Transcript of COH.AX earnings conference call or presentation 16-Aug-19 12:00am GMT

Full Year 2019 Cochlear Ltd Earnings Call

New South Wales Aug 19, 2019 (Thomson StreetEvents) -- Edited Transcript of Cochlear Ltd earnings conference call or presentation Friday, August 16, 2019 at 12:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Dig Howitt

Cochlear Ltd. - President and CEO

* Brent Cubis

Cochlear Ltd. - CFO

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Conference Call Participants

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* Andrew Goodsall

MST Marquee - Analyst

* David Low

JPMorgan - Analyst

* Chris Cooper

Goldman Sachs - Analyst

* Sean Laaman

Morgan Stanley - Analyst

* John Deakin-Bell

Citigroup - Analyst

* Saul Hadassin

UBS - Analyst

* Steve Wheen

Evans and Partners - Analyst

* Gretel Janu

Credit Suisse - Analyst

* Lyanne Harrison

BofA Merrill Lynch - Analyst

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Presentation

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Dig Howitt, Cochlear Ltd. - President and CEO [1]

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Good morning, welcome. And we are ready to go. I know we have people following the webcast, as well as here, so thank you for joining us. For those on the webcast, I am Dig Howitt. I will give an overview of some of the highlights of the year, some of the progress in the last year. Then Brent will talk about the balance sheet, the P&L, and the cash flow. And then I'll come back with -- to finish with our guidance and a brief overview on our strategy.

But let's get underway. So highlight clearly for the year was the growth in services and sound processes. And that continues a several-year trend of year-on-year growth from our services business, which is now 30% of our revenue. It was obviously a slower year for cochlear implants, both in developed markets and in emerging markets. I will talk on the next slide into more detail on those. But I think we go into F2020 very well positioned in both developed and emerging markets, and expect to see strong CI growth through F2020.

Very importantly, we are running the business with a long-term view of investing to drive growth; and that we have this very significant opportunity we've talked about both in emerging markets and in adults and seniors in the developed markets. We made continued investments in the last year in furthering our strategies in these areas. And some of the highlights of that was continuing to grow our investment in R&D. So up nearly to 13% of sales in the last year.

I said, at the half-year, that we had a very strong technology pipeline over the next 18 months. We've clearly launched some important products in the last 6 months. We still have a strong pipeline, looking forward, over the next 18 months. And I will talk to that when I come back at the end.

The work we've done on direct to consumer continues to be a very important part of driving consumer awareness of cochlear implants and candidacy. We continue to expand that across the globe, and to see both referrals and surgeries coming from that. And, increasingly, we are doing some work on the hearing aid channel that we know, in the adults and seniors segment, the majority of our future potential customers are in the hearing aid channel.

We want to work to build a clinical path from hearing aids through to cochlear implants, so that there is a much more seamless transition for people with hearing aids with severe to profound hearing loss to cochlear implants if they meet the candidacy criteria. We have made some good progress on that, in the US particularly, over the last year with our Cochlear Provider Network, and we continue to learn more about that channel and the opportunities that channel presents for us.

Market access is critical that we continue to expand the indications and expand the availability of funding so that people who will benefit get funded for implants. We saw, a few years ago in Japan, the expansion of indications in Japan again performed well; strong cochlear implant system growth in the last year. That is the second year in a row since expansion of indications.

As we announced earlier in the year, the UK indications were expanded in March, effectively doubling the size of the potential market in the UK. We expect that to see an uplift over time in cochlear implant surgeries in the UK.

We have a number of applications in with payers around the world for expansion of indications, or expansion of funding based on evidence of the efficacy of our products and quality-of-life improvements. We would hope to see expanded funding in indications continue over the years.

And, importantly, now a few years past the launch of the 532 implant, we have completed a significant benchmark study using the CI532 in Nucleus 7. So that study, we expect to publish in the next few months. It has been a comprehensive study. It showed both significant improvements in hearing performance for people moving from high-powered hearing aids -- to high-powered hearing aids to a cochlear implant; or a cochlear implant and a high-powered hearing aid. And it showed very significant increases in customer satisfaction with their hearing outcomes in a whole range of listening environments, including using the telephone, listening to music, speaking -- listening when there's background noise.

We shared some of that data at our Capital Markets Day earlier in the year. That study will be published in the next few months, and we'll have all of that data available. But, importantly, there's also improvements in quality of life data. And that study set is important for payers to be able to show improvements in quality of life, and improving performance for people in criteria -- from hearing aids to cochlear implants -- it's an important part of building this clinical path from hearing aids to cochlear implants [as well].

And we finished the year in a strong financial position that Brent will talk about. Our balance sheet remains conservatively geared; our dividends continue to grow; and we are well set up for a strong year in F2020.

So let's now move on to look at implants. I'll talk about developed markets and emerging markets. Because, clearly, our overall implant units fell 3%; our development market units were in line with last year; emerging market units were down.

So let me dig into each of those a little bit more. So firstly in developed markets -- we talked about this at the half-year -- we've lost share particularly in the US in Germany. Now we have now launched the Profile Plus implant in May in Germany, in the last week of June in the US. We are seeing we are regaining share in those markets since the launch. And that does give us competence for strong implant growth as we go into F2020. We continue to roll out the Profile Plus country by country as we get registration or as we get regulatory approvals because it is an important product in our portfolio.

The other thing we said at the half-year was we have seen in, Western Europe, that our sales were flat, and that we were running into some funding caps and indication constraints. We also said at that time that when we look back over time, we see that there had been long run growth in Europe, but individual countries have moved up and down over time. That growth was not necessarily consistent across every country.

What we saw in the second half, and leaving the Profile Plus aside; but in Western Europe excluding Germany, we saw high-single-digit growth in cochlear implants, indicating that those Western European markets grew in the second half versus being flat in the first half. So that's certainly a good sign as we head into F2020 that that long run growth in implant numbers in Western Europe -- we believe that should continue. And so in developed markets, we've seen we were gaining share. Profile Plus is a very important product; and so, therefore, we expect a strong F2020 for developed markets.

Now emerging markets, there are really four factors in emerging markets which led to our decline in sales for the year. And we think that when we look at those factors, when we look at F2020, we believe the underlying market for cochlear implants in emerging markets continues to grow, and will grow in F2020.

But as we've said several times, there is inconsistency in that growth for a whole range of reasons. So let me go to those four things. The first of those is China. So in the China tender, we had 700 fewer units in F2019 compared to F2018. That's because we didn't win a tranche of that tender, so obviously cycling that through.

In both Turkey and Argentina, which are 2 important emerging markets for us, macroeconomic conditions, as I'm sure you are aware, were bad in both those countries; significant currency devaluation, recessions in the countries. We saw a very, very significant decline in our sales in those 2 countries. Just those three things together account for more than our total fall in cochlear implant sales in the year.

On top of that, there are 2 other factors. One of our long run strategies in emerging markets has been to increase our presence by going direct in some markets by putting more people on the ground. In the last year, we went direct in some key markets, emerging markets. You can see that in the balance sheet. We've had to acquire some of our distributors to do that. Now when we do that, it is the right thing for long run growth. And if you look at the Middle East and Eastern Europe which were two of our standout regions for emerging market growth in the last year, we invested people on the ground in Dubai and then in Vienna for Eastern Europe, three and four years ago. We are seeing the benefit of that come through now.

But in the year when you make those changes, there is some short-term instability, particularly when we are working through distributors. When we replace those distributors, we end up buying back a couple months of inventory. So we have a few months where we don't sell. So we had that as the third factor in emerging markets of missing a few months' sales in some key markets as we took back inventory from distributors.

An the fourth factor is that we did win some very significant tenders through F2019 in some emerging markets. Those tenders didn't ship in 2019. We've started to see some of those ship in F2020. So we are carrying a good order book through in emerging markets.

So we think all of those factors are hitting F2019 for emerging markets. We think will either cycle through or resolve more favorably, leading to growth in emerging markets for implants. So we are confident of our cochlear implant system growth for both emerging and developed markets going into F2020.

We'll now go to services. As you can see in the chart here that we have had good consistent growth in services over the last 5 years. That's been on the back of a few things. Firstly [Canto] was in the strength of Nucleus 7. It's also the work that we have been doing to improve connection and engagement with our customer base. You can see now that we have over 140,000 members of Cochlear Family. That's a 40% increase on the last year, and that's an important element for our future engagement.

Now we are, with services, starting to get later in the cycle of Nucleus 7, so we expect services to continue to grow. But we wouldn't expect the growth rates that we have seen in the last few years to continue as we look forward. And you can see that if you look at first half/second half, slight slowing of the growth in the second half, but also very good comparables for us from a services perspective. So a very good long run opportunity, 30% of our revenue now. We continue to engage and connect which helps drive the underlying growth, and continue to have a very strong product portfolio which encourages people to upgrade.

Onto acoustics: acoustics, 12% of our sales, down 1% in constant currency in the last year. The cause for that was a reduction in the upgrades that we saw. We are now a few years past the Baha 5 system launched so we've seen a cycling of the upgrades coming off. But importantly is the OSIA implant system which we plan to release later in F2020. We've been conducting trials on that product through this year.

The feedback from those trials has been very positive. It is a product which really stems and expands our acoustic implant portfolio. And acoustic implant opportunity is very significant. We think this product helps open up that opportunity as an addition to our product range. So more to come on that as we go through the year; but very, very positive feedback from the clinical study that we have taken.

Now just quickly through the regions, just to show the regional performance. You can see in the Americas, sales down just slightly. That was both a function of Argentina and Latin America; and in the US, good services growth but not as strong a growth -- or the CI number we lost share. But as we said, with that launch in the last week of June, we are regaining share since the launch.

In EMEA, you can see consistent growth there. Obviously services was a stronger contributor to growth than cochlear implants in the last year. But again in Germany, with the launch in May, we have seen us starting to regain some market share, albeit early days in the rollout of that launch.

And then Asia-Pacific, again, 2% growth, so cycling the 700 units in China tender. But in Asia-Pacific, our core of our strategy there is to invest, is to put people on the ground to make sure that we are well positioned for long run growth. Because there's absolutely long run growth in Asia-Pacific; we've got a make sure that we are very well positioned and we are investing to do that. And continue to seek good performance in Japan on -- as I said earlier -- on the back of the indication expansion 2 years ago.

So with that, I'm going to hand over to Brent to talk through some of the financial results. And I'll come back at the end to finish with a strategy overview and our outlook.

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Brent Cubis, Cochlear Ltd. - CFO [2]

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Okay, thanks, Dig. So Dig has already touched on the P&L on the revenue side. So I will go to the P&L and focus on little bit more on the highlights there. Now as Dig mentioned, upgrades is the highlight this year on the revenue line. So underneath that, there is 17% growth in the upgrade business in sales, and that is being diluted by the CI. But we are really happy with this result, given those headwinds we faced that Dig mentioned before.

We've really managed the business hard this year. And you can see that we did not deviate from our long-term strategy in investing in the sales and marketing and the R&D area. And I think that's a really good achievement, given those headwinds we spoke about before. So you can see that 9% growth there in the sales and marketing and R&D over last year in constant currency.

And we've done that through working hard on the savings in admin. We actually went down in admin. So we've probably reviewed 200 contracts in the last couple years and put out some good cash savings in those contracts, so that's coming through now which I'm really happy to see. But further up, you can see the improvement in the gross margin. And that 3 percentage points is worth about $40 million which we have reinvested into those areas that you can see there.

The other good work we've done is managing our interest and our cash flow really tightly, and some good tax savings as well. Part of that is due to the 12 months of the US savings versus 6 months last year, after Trump changed those back in December 2017. And there's some non-cash items as well which brought that effective tax rate down. So that will probably be close to 25.5% -- probably about 26% going forward.

So, overall, we've worked the business hard to make sure the long-term strategies don't suffer because it's important that we keep with that strategy.

You've already seen the results of the innovation fund. So we're just going to be focusing on the net profit on the -- the underlying amount, the $266 million we'll be with the base that we use for our guidance for our growth.

Moving forward to the cash flow, another great year on our cash flow: $296 million there. That's about 111% over the $266 million underlying profit. That is a good result mainly because of the tight management of our debtors and so forth, which will see on the next slide, which stayed about the same year-on-year despite sales going up. And overall in the balance sheet here, you can see how that's been possible.

Credits went up a little bit because towards the end of the year, we are building our inventory with Profile Plus because that's the reason that's the reason they went up.

And the other items that we've invested in there in China and some of the other investments Dig mentioned before. You can see them at the top of the screen there. The GN collaboration which goes -- which we announced during the year, the 10-year agreement there. The investment in Nyxoah in the first half is towards the bottom there. And as Dig mentioned, before we did invest a little bit in some of those distributors in the emerging markets.

So, overall, the balance sheet and the cash flow are in very good shape. And that's enabled us to keep our net debt position -- it has only gone up by $10 million despite spending about $140 million on CapEx items and investments. So I think that's a pretty good achievement. And we're very proud of that. You can see over the last few years, we spent about $400 million in CapEx and other investments in Sycle and Nyxoah and so forth, and our debt hasn't gone -- it has actually come down over that period. So we are very happy about that, and we continue to manage that very tightly.

Part of the reason why that interest came down, as well, was because we did renegotiate that loan with the SEK loan in Sweden which had a low interest rate, but overall it is just managing it really tightly and keeping that debt down.

All of that has enabled us to pay a 10% dividend year on year, and you will see -- you can see that there. A 70% payout ratio, and we're very confident going forward that this enabled us to pay that dividend.

Finally, in terms of -- Dig, you're going to go on to the guidance. I think you're going to have that slide there with the -- there's a really good presentation that we've included with the results of our strategic outlook. It goes back for 20 years, and showing the history of the company. I would encourage you to look at that as well.

And Dig has got a couple of those slides to look at too.

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Dig Howitt, Cochlear Ltd. - President and CEO [3]

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Thanks, Brent. So, yes, it's a quick recap of our strategy before we go to questions. So number 3, things we are trying to do: retain market leadership, which is really about our product portfolio and our customer service. We have to grow the market which is awareness, access, and clinical evidence is important. That's where the 532 study is an important part of helping us grow the market. And we are aiming to deliver long run revenue and profit growth by getting operational improvement, reinvesting that in growth or in technology, maintaining our net profit margin as we go forward.

So our product portfolio is core to our competitive position and we have advanced that portfolio over the last year -- in particular, in the last 6 months -- with the Nucleus Profile Plus, Nucleus 7. We have added ForwardFocus which helps people hear much better in the background noise and we've got some very good clinical results on that. Remote Check is in a pilot stage in the UK, enabling people as we've said to be able to do their checkups at home rather than coming into the clinic. So relieving clinic capacity, lowering the overall costs of the intervention.

The ECochG Research Platform is now available, and Google have announced that they will be putting the ASHA protocol into their next generation of Android phones. Our system is already enabled for that. So once those phones are available, people will be able to stream from an Android phone to Nucleus 7, as they can from an iPhone to Nucleus 7 now.

We think about -- as we've talked about, we think about our strategy in terms of 3 market segments, with adults and seniors in developed markets being the most significant opportunity for us with only 3% penetration. People living longer, an aging population, but still losing their hearing at the same rate, so very significant opportunity for us.

Children in developed markets, as we've said, highly penetrated. But important that we hold or grow our share in that area, and remembering developed markets make up 80% of our total revenue. And then children in emerging markets is absolutely an opportunity for long run growth. And we've been very clear that we will invest to put people on the ground to expand funding to educate surgeons, build the infrastructure and audiology on therapy so that there is long run growth and effective outcomes in emerging markets.

A very important part of that is how we invest. And the framework for how we invest is we want to maintain our net profit margin so that we can continue to pay a good dividend. We want to maintain a conservative balance sheet. Within that framework, we then want to generate operational efficiencies and invest those into the business, as Brent went through. We've done that in the last year by expanding our R&D, expanding our sales and marketing, and building things like the factory in China which set us up with more capacity into the future. And enable us -- over time, we want to continue to bring our cost of production down and work on our operational efficiencies to drive more money back into reinvesting into the future.

As Brent said, we've published a strategy document that has a 20- or even 25-year view of our financial history. It is up on our website today. It's -- we provide it there for you, just so that you get good background into the long run financial history, and can see the long run trends which we show off here in our business.

So just before we get to guidance, then I'll remind the 3 areas of growth. Our cochlear implants, I've talked about those; service, which has continued to grow well over the last several years; and acoustics where again we see long run opportunity and expanding our product portfolio to really grow that acoustic segment in the long run.

Now moving to our guidance so guiding for net profit of $290 million to $300 million, which is a 9% to 13% increase on our underlying profit, the $266 million for this year. Strong growth in cochlear implants is the core driver of that uplift, as we've said, and that's both in developed markets and in emerging markets for the reasons I outlined earlier. We do expect to release the OSIA system during F2020, so expect some contribution later in the year from that.

Our CapEx will go to $180 million this year. And that's really driven by 2 things. The majority of the China factory building and fit out will be completed this year. And in Denver, because of the growth of the business, we are moving to a new and larger office. And the CapEx -- the fit out of that office is quite significant and will happen this year.

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Brent Cubis, Cochlear Ltd. - CFO [4]

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In Denver.

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Dig Howitt, Cochlear Ltd. - President and CEO [5]

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In Denver, yes, in Denver; and we then expect to go back to about $100 million in CapEx in F2021. Be aware of the lease accounting change that comes into effect this year. That will reduce our pretax earnings by about $2 million to $3 million this year. That's obviously included into our guidance. We have excluded any revaluation of the innovation fund as we did from -- between our net profit and underlying profit this year. This guidance doesn't include any revaluation up or down in that fund.

As we've said, we want to retain our net profit margin. So we expect to grow revenue well this year, hold down our profit margin, reinvest that difference back into the business as we get more operational efficiencies.

And we've been working off -- our guidance is based on exchange rate of $0.70 to the Australian dollar, EUR0.62. Spot rates are below that today. We will see where they go over the year. But given the volatility there, we thought it was important to set out the rates that we had used in providing that guidance.

So we will finish up there and now open up for questions.

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Questions and Answers

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Dig Howitt, Cochlear Ltd. - President and CEO [1]

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Andrew, first up. We put our financial history up on the slide for you to look at.

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Andrew Goodsall, MST Marquee - Analyst [2]

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That's very much. It is Andrew Goodsall from MST Marquee. Just obviously you have had the benefit of the Profile Plus in the market since May. So you're a couple months in. Just try and get a sense if you're feeling that that's giving your back the market share that you perhaps said before? I guess a blip with the MRI type issue.

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Dig Howitt, Cochlear Ltd. - President and CEO [3]

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Yes. So, look, it's -- we've now a few months in Germany, about 6 or 7 weeks in the US. And we -- this has been very well received by consumers and by professionals. We are regaining share in both those countries.

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Andrew Goodsall, MST Marquee - Analyst [4]

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And would you characterize that as basically back in the run rate where you were, or is it still a work in progress?

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Dig Howitt, Cochlear Ltd. - President and CEO [5]

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Look, we're still rolling out. But as I said, we are not in all countries yet. But in the countries where we are, particularly Germany and the US, two big ones, we've seen a lift up. But even in the US we are not into -- we said lift up in our share, lift up in our sales. In the US, we still continue to add hospitals, registration; but very pleased with the reception and how that product has rolled out and what we are seeing in our sales.

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Andrew Goodsall, MST Marquee - Analyst [6]

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Okay great. And one for Brent, just in terms of the accounts, could I just get a sense of net movements in provisions? Looks like (technical difficulty) a bit over 7, and contingent considerations like Sycle. I think first half you had 5.

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Brent Cubis, Cochlear Ltd. - CFO [7]

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So in terms of provisions, we've also got -- we had that change in accounting standard last year, the deferred revenue. That's one of the big contributing factors to it. You've seen in the notes, the Sycle remaining provision is about $19 million or so, and that consists of a little bit the referrals as well. And Dig can talk to how we are going to treat that for the next year.

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Andrew Goodsall, MST Marquee - Analyst [8]

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What would be the net movement in those -- across those items, then, year on year, in both provisions and contingent?

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Brent Cubis, Cochlear Ltd. - CFO [9]

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I mean, year on year -- you've obviously seen how much we released for Sycle this year. So that one has come straight to the P&L, about $10.8 million, which we have called out, leaving the $19 million or so for next year. If you're just talking about Sycle and all the other provisions, there's ups and downs whether it be deferred revenue or employee provisions and whatnot, things like that.

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Andrew Goodsall, MST Marquee - Analyst [10]

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Okay.

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Brent Cubis, Cochlear Ltd. - CFO [11]

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We've also outlined, on the capital employed, where some of that has gone. The other side as well -- on the intangible assets as well. So on the other side. So things like the GN and so forth.

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Dig Howitt, Cochlear Ltd. - President and CEO [12]

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So of that $19 million for Sycle, there's -- $13 million of that which is for part of the revenue earnout, and the other $6 million is for referrals. In setting up our guidance and our budgets for this year, we have assumed that Sycle will meet its revenue targets for -- and earn that $13 million. If -- as happened this year, they didn't achieve those targets, than that $13 million comes back through the P&L. And if that happens we will look to do what we did this year, which is to pull forward some spending to invest into the future. But at the moment, we assume that Sycle will meet the revenue targets.

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Andrew Goodsall, MST Marquee - Analyst [13]

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Thank you.

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Dig Howitt, Cochlear Ltd. - President and CEO [14]

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The referral ones have another year after that. So they had [2021]. So that's why there will be a little bit left at the end of next year.

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Andrew Goodsall, MST Marquee - Analyst [15]

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Got it, thank you.

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Dig Howitt, Cochlear Ltd. - President and CEO [16]

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So we are now going to questions on the phone.

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Operator [17]

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David Low, JPMorgan.

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David Low, JPMorgan - Analyst [18]

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Thanks very much. If I could just start with the Profile Plus and the implications. I heard the comments about it rolling out and getting hospital approvals. Would we be right to assume that the first half will probably continue to have a bit of a lag, negative impact as the product is not out in all the regions?

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Dig Howitt, Cochlear Ltd. - President and CEO [19]

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So we are out in the US and Germany, which are our 2 biggest markets. We have also gone into the UK, which is another big market. And we are progressively going out through Europe. So we expect it to roll out pretty quickly through the first half, through the rest of Western Europe and get to the remaining hospitals in the US. We always do tend to have a lag into Australia, Japan, based on timing of regulatory approvals. But the majority of our developed markets sales -- Profile Plus will be available for the majority of our developed market sales pretty quickly in this half.

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David Low, JPMorgan - Analyst [20]

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So your first half is pretty normal, then; obviously not necessarily a good comp last year, where you didn't have that product for a period. Would that be fair?

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Brent Cubis, Cochlear Ltd. - CFO [21]

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I think I understand your question. It will be -- the Profile Plus will be available in most markets through the second half, for sure, and for most of the first half. And remember just in terms of what we are cycling from last year for the US, the first 2 months were -- we retained our shares from September on that we lost some share in the US in terms of the comparable.

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David Low, JPMorgan - Analyst [22]

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And if I could just follow that up with Dig. I mean what is the learnings from the Profile Plus and not having an MRI compatible device? It's all easy with hindsight. But what would you do differently or what would you like to do differently?

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Dig Howitt, Cochlear Ltd. - President and CEO [23]

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Good question. I think a few comments on that one. The first thing is our competitors should be looking for holes in our product portfolio and trying to exploit them. That's what they should do; that is what they do do. And so one of the things we've got to do is respond quickly when that happens. I think we did that. We do look at our product portfolio going forward. We look at what we believe our competitors will do going forward, and we try to anticipate where there might be a hole. I think [you can] say -- we can say we are more rigorous in that assessment going forward than perhaps we have been.

And I think the other thing we learned out of this, which is good, is that over the last 4 years, up until this year -- the 4 years up until this year, we had very, very strong product portfolios and some very good product launches. We had been gaining share on the back of those launches. And what we had to do in the last year was sell when we didn't have a full deck of cards. And I think that's (inaudible) good for the organization and good for focusing us on what really are our strengths, and enabling us to prove the strength of our selling capability around the world.

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David Low, JPMorgan - Analyst [24]

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Great, thanks very much. If I could just squeeze one in for Brent, just on -- I heard the comments about cost management. And we did see sales and marketing, you continue to invest there. But admin, as you say, went backwards. What do we expect for FY2020? Do you end up having to rebalance for that after you squeeze everything tightly that you get some of those admin costs come back? Anything we should think about with those expense lines, please?

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Brent Cubis, Cochlear Ltd. - CFO [25]

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As the guidance says, we are maintaining our profit margin. So that will be our focus and we will always do that, so we will flex wherever we can in that area. I was very happy that we didn't pull back on the sales and marketing R&D. But we won't get those benefits in admin next year, as you pointed out. We do have more depreciation coming forward, as well, which will probably -- a lot of that will go through that line.

So overall, though, I think if you just look at the total operating expenses, just thinking in terms of the net profit margin will remain the same. So in terms of any modeling or anything like that, just keep that net profit margin the same and we will balance in between.

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David Low, JPMorgan - Analyst [26]

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No, you certainly make it easy for us with the modeling. Thanks very much. I will leave it at that.

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Brent Cubis, Cochlear Ltd. - CFO [27]

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We have worked very hard on those savings, I can assure you. 200 contracts we've reviewed, and we put out a lot of cash. You start into -- we've got the low-hanging fruit first, so it's a bit hard to get the next lot.

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Operator [28]

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Chris Cooper, Goldman Sachs.

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Chris Cooper, Goldman Sachs - Analyst [29]

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Thanks for taking my questions. Just beyond the market share dynamics, can I just ask one on general market growth? Clearly, you've talked to some of the challenges you've seen in Europe and the emerging markets today, but can you give some comment on the US? It seems to us that if we add up you and your competitors, the US situation isn't quite as rosy as we've seen in the recent past. Can you just provide some commentary around that, please?

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Dig Howitt, Cochlear Ltd. - President and CEO [30]

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Thanks for the question. I think that's right. I think in the US, where we have a very significant share, if we don't have a feature that is getting promoted and that some customers want, then that will have some impact on market growth and I think we saw that in the last year.

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Chris Cooper, Goldman Sachs - Analyst [31]

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Okay, but beyond the lack of a [free tested] product from you guys in the US, you believe the market otherwise is as it was through the last 2 or 3 years?

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Dig Howitt, Cochlear Ltd. - President and CEO [32]

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Yes. Look, we continue to see good growth in that market. So as I said, the core of our focus is on adults and seniors. That is very clearly the fastest-growing part of our business right around the world. We continue in the US to work with our direct-to-consumer strategy. We continue to expand the Cochlear Provider Network. Those things are meaning -- small but meaningful contributors to our growth and of growing importance.

And there is, as we've said over time, still some opportunity to grow in children. The penetration in children in the US is between 50% and 60% which is below many other developed countries. There's some structural reasons why that's the case, but hopefully over time we can break those down. So I would expect, yes, the US market to continue to grow. And the growth rate in the US was -- we would say probably a little bit slower in F2019 than previous years, and think it will move back up in 2020.

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Chris Cooper, Goldman Sachs - Analyst [33]

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Okay thank you. And just a couple quick ones if you don't mind. So just on CapEx, this year again you came in ahead of your guidance, and this was the second year where you are guiding to quite a big jump. Can you just remind us -- I think you said it on the call, I just want to confirm -- the China projects in terms of manufacturing, you expect that to be completed by the end of fiscal 2020? And what does that give you on gross margins?

And then very last question, can you confirm specifically what it was within the innovation fund that drove the profit uplift? Thank you.

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Dig Howitt, Cochlear Ltd. - President and CEO [34]

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Yes. So on the China factory, what I said is the majority of -- the factory we built and the majority of the fit out completed this year, therefore the majority of the CapEx goes in. We then still have to go through the process of regulatory approvals before we can build significant volumes of product in that factory. So that will take another few years.

So you won't see a gain in the gross margin in the near-term on that. And in fact, actually, with the extra overhead from the factory, there will probably be a little bit of a drag on the gross margin -- not a lot in the scheme of our cogs -- when we first start production. So that was the first part of the question.

The second part -- innovation fund.

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Chris Cooper, Goldman Sachs - Analyst [35]

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Just on the innovation (multiple speakers)

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Dig Howitt, Cochlear Ltd. - President and CEO [36]

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Yes, yes. So that -- look, this is what we can say because it was public; it was the newspaper. That was Saluda. So Saluda did a capital raising late in the year. And they did that at an increased valuation, and that was the driver behind the increase in that value.

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Chris Cooper, Goldman Sachs - Analyst [37]

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Got it. Thanks for the help.

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Operator [38]

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Sean Laaman, Morgan Stanley.

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Sean Laaman, Morgan Stanley - Analyst [39]

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Thank you. Good morning, Dig; good morning, Brent. I have a question on the upgrade cycle. I know there has been a lot of focus from the company to really drive penetration compared to past cycles. But is there anything you can tell us on what you have been able to achieve so far on the penetration of the N7 upgrade cycle, and what you might have seen in the past?

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Dig Howitt, Cochlear Ltd. - President and CEO [40]

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Yes. So we have increased the penetration by a few percentage points over what we've seen in the past for the same stage. So that's encouraging because of the work we've done on trying to connect better. We are getting later in the cycle. And so we expect to see continued growth in services, but not at the same rate that we have seen over the last few years. And obviously our goal is to continue to expand that penetration. And we continue to experiment and learn and find better ways of doing that and learning across from practices in different countries as to what is successful and what is not.

It's a core reason for building Cochlear Family is to enable people to connect better with us. Now, I think the benefits from Cochlear Family is actually 5 years after we sign people up to it, when, if they are new, become eligible for recipient, or if they've just come in now because they can upgrade. So the growth in Cochlear Family is important but it's not a short run driver of increased penetration. But I think it will be a longer run driver.

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Sean Laaman, Morgan Stanley - Analyst [41]

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And one more. Just how significant is this 532 study in terms of -- wrong word -- but strong-arming sort of potential recipients into the pathway? Or is it just another part of the ongoing arm wrestle in trying to crack the channel?

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Dig Howitt, Cochlear Ltd. - President and CEO [42]

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It certainly -- it is the most significant study that we have done. It is that part of the ongoing work to build a clinical path from hearing aids to cochlear implants and being able to measure directly quality-of-life and hearing performance and satisfaction with hearing from people when they've got two high-powered hearing aids, before they get a cochlear implant; and then after they have a cochlear implant, or a cochlear implant and a high-powered hearing aid, and see a very significant difference.

It hasn't been done before. And I think it's very important both for payers, for consumers to have confidence, and to be able to -- for us to be able to educate the hearing aid channel on the outcomes that people can achieve with a cochlear implant or a bimodal solution. So it's an important study, but it's a step on the path as we try to expand that adults and seniors segment.

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Sean Laaman, Morgan Stanley - Analyst [43]

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Okay, that's all the questions I have. Thank you, Dig.

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Operator [44]

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John Deakin-Bell, Citigroup.

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John Deakin-Bell, Citigroup - Analyst [45]

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Good morning. Just wanted to ask a little bit more about China. Obviously it's going to take some time before you've got the plan up and running. And obviously you've been less successful in China than you've been in the rest of the world over time, which is unusual for your business. Can you give us a feel for what the strategy is to get some of those tenders back in [people] are using your product?

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Dig Howitt, Cochlear Ltd. - President and CEO [46]

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So, China -- I think, firstly, the national tender is becoming a much less significant part of the China business than it used to be for a while. Earlier on it was half the revenue, and then it was half the volume. Now it's less than half the volume, and half -- well less than half the revenue. What we are seeing is some of that tender money being [devolved] more to provinces. But the private pay market which is really the -- where most of the volume and definitely most of the value is derived in China.

The key to being -- for us to be successful here is to get people on the ground to make sure that we have strong relationships. China is many large cities, and we've got a get people into these cities who are working on a referral path and getting people into hospitals. That's what we've been investing in, and making sure that we have a strong product portfolio there as well.

So China is very much a long-term play. That's where the factory comes into that as well. It has been a market -- the private pay market has grown very significantly over the last 20 years, over the last 5 years. But it still has the -- the potential is all into the future still for China, and we're making sure we are set up to take it.

John, I think that answers your question. So if it doesn't --

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John Deakin-Bell, Citigroup - Analyst [47]

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It does. I just ask one more, given (inaudible). Just so we're clear, you've relaunched your MRI-compatible product. You've obviously lost market share for 6 or 9 months in the US. How does the conversation between the salespeople and the surgeons or the audiologist go? Is it as simple as back to business as usual, and all of a sudden two thirds of implants are yours? Or can you give us a bit more color on that process to winning back the market share?

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Dig Howitt, Cochlear Ltd. - President and CEO [48]

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Look, it is very much -- it varies a bit by market. But it is very much -- it takes MRI off the table as a discussion point, and gets back on hearing outcomes. MRI is actually a negative selling point, in a sense. It is highlighting the risk of getting an implant, not the benefits. People get an implant because they want to improve their hearing.

And what us having the Profile Plus does is enable us to focus the conversations on the benefits of perimodiolar or electrode rays on the outcomes that we see with Nucleus 7, on the connectivity and the streaming and comes with Nucleus 7. They are very strong selling points for us, backed with evidence. And that's where the conversation goes back to after initial explaining [who's our] MRI. People expected that we would be bringing a 3-Tesla compatible implant to market, and on the whole, are pleased that we've done that.

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John Deakin-Bell, Citigroup - Analyst [49]

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Right, that's good color.

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Operator [50]

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Saul Hadassin, UBS.

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Saul Hadassin, UBS - Analyst [51]

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Dig, maybe just to push the Nucleus profile recovery question a bit further. So in the slide pack, you mentioned uplift in sales in the US post-launch, and also sales (technical difficulty) growth in Germany since launch. Does that imply growth for the first couple of months since launch is up on the [PCP pew], which was a normal period during which the competitors hadn't launched? Just some I guess additional color on -- are you actually saying return to, say, market growth in those 2 countries now?

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Dig Howitt, Cochlear Ltd. - President and CEO [52]

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Okay; understand the question. So just on -- just to give more color on Germany is that in Germany, the MRI was -- had been there for most of F2018. And we have seen an uplift in our sales since that launch; over the period before the launch, and over comparable. So in the US, we have also seen an increase. And that increase is more significant obviously over the few months before the launch than it was July on July, given to your point that MRI compatibility wasn't an issue in July last year, or July and August last year. But we have seen growth.

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Saul Hadassin, UBS - Analyst [53]

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Thank you, Dig. And Dig, if I could just ask you on the new osseointegrated device, that steady-state device: can you just describe or give us some more detail? I assume it is the conductive hearing loss. Is that the case? And how does it differ from Baha?

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Dig Howitt, Cochlear Ltd. - President and CEO [54]

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So it is for -- it's -- yes, for conductive or mixed hearing loss. It's a piezoelectric stimulator, so that -- so an implant. I can't say too much about it, but I can say little bit about it. It is an implant -- look, what we've seen in the trials is it gives very good power out across a very broad frequency range. The thing about acoustic hearing is it's really natural hearing. And provided you get power out, put across a broad frequency range, that delivers the best natural hearing. So that's what we are seeing in the study.

The surgery is relatively simple. And, very importantly, the cosmetics the device, the appearance is very attractive relative to the alternatives. And that's why we're getting very strong feedback from both the customers in this trial and the surgeons who have been involved.

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Saul Hadassin, UBS - Analyst [55]

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Dig, does it expand that patient category within the conductive and mixed hearing loss segment, or does it cannibalize Baha?

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Dig Howitt, Cochlear Ltd. - President and CEO [56]

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We think it will expand the category. I think there will be some cannibalization. But the penetration of acoustic [inpol] Baha into conductive or mixed loss is very low, and probably even lower than cochlear implants. And I think the form factor of the device is certainly part of that. And by having clinical results showing outcomes, it gives us the opportunity to talk to more surgeons, talk to more ENT surgeons that aren't necessarily involved, certainly, with cochlear implants, to be able to expand the surgical outlets, surgical clinics.

So we think we expect to see this expand the market over time. Now any market expansion takes time, because there's education and training and so on. But we do see strong potential to do that with this product.

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Saul Hadassin, UBS - Analyst [57]

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Thanks, Dig. If I can just squeeze a last quick one in for Brent. Brent, just looking at the other income category, there is a line item there that is called other income that is up $3 million from last year -- it's up to $5.5 million. I'm just wondering what that is, and is that recurring other income?

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Brent Cubis, Cochlear Ltd. - CFO [58]

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We just got some grants and things like that from different countries around the world. Sometimes I wouldn't say it's all recurring; depending on the year. And so I would back out a little bit if you're worried about recurring.

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Saul Hadassin, UBS - Analyst [59]

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Thanks.

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Dig Howitt, Cochlear Ltd. - President and CEO [60]

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R&D.

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Brent Cubis, Cochlear Ltd. - CFO [61]

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Mainly in Europe, and they are a bit lumpy because it depends on when you submit them and so forth.

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Saul Hadassin, UBS - Analyst [62]

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Okay, that's very helpful. Thank you very much.

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Operator [63]

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Steve Wheen, Evans and Partners.

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Steve Wheen, Evans and Partners - Analyst [64]

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Good morning. Just back on the guidance, just curious with that contingency provision around Sycle reversal, you haven't kind of put that -- removed that from your earnings to come up with an underlying number. Just curious as to why you haven't done that. And, therefore, I guess the underlying growth rate for FY2020 is perhaps a bit stronger because you're not expecting to have a similar provision in FY 2020 by the sound of it. Is that correct?

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Brent Cubis, Cochlear Ltd. - CFO [65]

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Yes. You can certainly -- we haven't removed it because you can do that, as we've called out the amount. And as I said, our guidance is set assuming that Sycle achieves the revenue hurdles, and therefore that money goes to the vendor. Now if that doesn't happen, as I said, we would look to pull spending forward, pull some future investment forward to invest into the future. So I think your underlying premise is accurate.

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Steve Wheen, Evans and Partners - Analyst [66]

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Okay. Just also on that litigation, you've got the provision I guess for the legal costs. But where are we with regards to the progress of that and determining a potential payout?

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Brent Cubis, Cochlear Ltd. - CFO [67]

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So the appeal is progressing. There's a process of exchanging briefs. We submit a brief; they submit a brief; we submit a brief in reply. That's all in process. We expect the appeal hearing to happen during the financial year, and likely that we will see a result of the appeal in the financial year. But I know that's -- obviously the timing of all that is beyond our control.

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Steve Wheen, Evans and Partners - Analyst [68]

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Okay, great. On working capital, obviously there has been an inventory build. Given your optimistic -- well, not optimistic -- but your strong rebounds that you are expecting in growth, would we expect a release of working capital, therefore, in the next half as you can deploy that inventory?

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Brent Cubis, Cochlear Ltd. - CFO [69]

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Yes. It will come down. There's a little bit of Brexit probably in there, as well, so we've just got to allow for that. And as Dig mentioned before, with the distributors, we took over a couple of those. So that inflated -- the big one is Profile Plus, but that will all be sold obviously; a lot of that in the second half and first half.

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Steve Wheen, Evans and Partners - Analyst [70]

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First half year?

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Brent Cubis, Cochlear Ltd. - CFO [71]

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Yes.

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Steve Wheen, Evans and Partners - Analyst [72]

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And then just finally the potential of the streaming capability on Android phones: what does that look like? And did you narrow that impediment to users of Android with your interim step? Or is this a quantum leap and, therefore, you could expect some uplift on the back of it?

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Dig Howitt, Cochlear Ltd. - President and CEO [73]

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Look, it's an important step for us. Streaming from Android's phones will be -- work in the same manner as it does from an iPhone now. It is -- for the streaming to work, it does need the new release of Android phone from Google, which I think happens probably around the latter half of this calendar year. So you can't stream from any Android phone you've got now; you need a new phone, new firmware. But in terms of how it works, or in terms of the functional performance, same as from an iPhone.

I think, look, it's certainly a very important feature to have. I don't think we have seen an inhibition in the take-up of Nucleus 7 because it doesn't have Android streaming. It's more it's a good positive rather than people have held off from either choosing cochlear -- I don't think anyone has held off choosing cochlear because we don't have Android streaming. And equally, from an upgrade perspective, I don't think people have held off because it's not there. It's just an important feature to add going forward from an improved connectivity and improved hearing outcomes for more people.

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Steve Wheen, Evans and Partners - Analyst [74]

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Okay, great. Thanks very much.

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Operator [75]

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Gretel Janu, Credit Suisse.

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Gretel Janu, Credit Suisse - Analyst [76]

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Thanks, good morning. Firstly on COGS, it declined 6%, but revenue was up 2%. So are there more manufacturing efficiencies to be gained here, and can we expect further decline in COGS in FY2020?

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Brent Cubis, Cochlear Ltd. - CFO [77]

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I think, as we mentioned before, it has been about a 3 or 4-year effort there, and we have squeezed it pretty hard. There's been a mix in there as well with the process, as compared to CI, so get a little bit of a higher margin there as well.

And Dig alluded to the fact when we go to China in a few years' time, that will probably dilute the gross margin a little bit while you're ramping up a bit in about 2 or 3 years' time. So we've squeezed the lemon pretty hard on the COGS. And I think we are not going to see a big improvement going forward. But we will work on other areas of the business to get efficiencies.

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Gretel Janu, Credit Suisse - Analyst [78]

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Thanks. And just on the unit sales this year, what was the proportion of adults versus children, and how strong are the unit sales growth in that adult market?

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Dig Howitt, Cochlear Ltd. - President and CEO [79]

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Okay. So that proportion varies by country. So Australia, the US, and Germany are about 75% of our system sales. 70% to 75% is adult/seniors. 25%, 30% is children across most of the rest of Western Europe; in Japan, it is more like 50-50. We've continued to see that adults is the -- across developed markets is the fastest-growing part of our business, an even a faster-growing segment than children.

And across emerging markets, it's virtually all children; it's 90%-plus of our sales into emerging markets are children. I don't know if we talked about -- I think there's very strong long-run potential. That market continues to grow. But the consistency of that growth -- it won't be consistent growth as we've seen over time, and as we've seen this year. But over the long run, that growth is there.

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Gretel Janu, Credit Suisse - Analyst [80]

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Okay. Thank you very much.

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Operator [81]

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Lyanne Harrison, Bank of America Merrill Lynch.

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Lyanne Harrison, BofA Merrill Lynch - Analyst [82]

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Good morning. Thank you for taking my questions. The first one is coming back to the services revenue, up 14% this year. You mentioned that the process of revenue will start to fall off a little bit. Should we still be expecting double-digit revenue growth from services for 2020. Or is there a chance that might step into the single digits?

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Brent Cubis, Cochlear Ltd. - CFO [83]

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I wouldn't expect double-digit growth. If you look in the second half, I think we had 9% growth in services in the second half. We are cycling two very big halves, as well, so I would expect -- we expect growth, but a lower rate of growth.

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Gretel Janu, Credit Suisse - Analyst [84]

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Okay, thank you. And one last question on I guess pipeline of products. So you mentioned you've got an exciting pipeline coming through, and you mentioned the acoustic -- you called out the acoustic device. Should we be expecting or what should we expect for the first half, second half, in terms of new launches?

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Brent Cubis, Cochlear Ltd. - CFO [85]

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I expect to watch the ASX website for our releases. (laughter) Sorry. That is a bit of a facetious answer. But we're not going to give guidance on timing of launches or the products that we may launch. I've talked about OSIA because it is public; there's clinical studies. There's public knowledge of that product. That's why we are talking about it. But we're not going to talk about other things that are not yet public.

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Gretel Janu, Credit Suisse - Analyst [86]

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Okay, thank you.

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Operator [87]

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Thank you. There are no further telephone questions at this time. I will now hand back to Mr. Howitt for closing remarks.

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Dig Howitt, Cochlear Ltd. - President and CEO [88]

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Okay. No more questions? Well, thank you for joining us.