Sonova Seeing Strong Execution Collide With Macro Uncertainties (OTCMKTS:SONVF)

Sonova Holding (OTCPK:SONVF) (OTCPK:SONVY) (SOON.SW) has built an enviable track record in the hearing care space. Not only has the company built upon its leading position in the hearing aid market over the past decade (now holding around one-third share), but the company generates strong margins, cash flows, and return metrics like ROIC. Now that legacy of operational excellence is colliding with some meaningful end-market uncertainties, as the 2023 macro-outlook deteriorates and the company will be coping with a new regulatory environment in the key U.S. hearing aid market.

I’m expecting high single-digit revenue growth from Sonova over the next three to five years, slowing toward a 5% to 6% growth rate over the longer term, and I’m expecting EBITDA margins to expand into the low-to-mid-30%s over the next few years. Between discounted cash flow and growth/margin-driven EV/revenue, I do think these shares offer enough upside to merit a closer look from investors.

Okay Results In The First Half, But Guidance Is A Little Soft

Sonova reported 5% organic revenue growth for its fiscal first half 2023 report, beating expectations by about 1% with CHF 1,847M. The Hearing Instruments segment grew 5%, with the hearing aid and audio care businesses both up 5% in organic terms (with reported AC revenue boosted by the Alpaca Audiology acquisition that closed earlier this year). The recently-acquired Consumer Hearing business contributed CHF 133M to revenue and did grow year over year, but management didn’t quantify the growth. Sales in the Cochlear Implants segment rose about 3%.

Gross margin fell 420bp yoy to 69.6%, as the company saw some adverse mix shifts and absorbed higher input, production, and distribution costs. EBITA declined 2%, meeting Street expectations, with margin falling 370bp to 21.6%. By segment, Hearing Instruments EBITA fell 2% (margin down 430bp to 22.2%), while Cochlear Implants EBITA rose 11% (with margin up 60bp to 13.6%).

When it came to guidance, management reiterated its 15% to 19% sales growth and 6% to 10% adjusted EBITA growth targets, but indicated that numbers were likely to come in on the low end of the ranges. Management had initially guided to 17%-21% sales growth and 12%-18% EBITDA growth when reporting FY’22 results back in May, but then revised lower in August.

In addition to steeper forex headwinds and the dilutive impact of acquisitions, Sonova is seeing worse-than-expected input cost pressures (not unusual in the sector these days), as well as weaker sales of its higher-priced products and in its higher-priced markets (particularly the U.S. private market). Management also commented that they expect to lose a private label contract in the U.S. that will weigh on sales – while management didn’t specify who the contract was with, I believe it was with Costco (COST).

A Growing Market … But Not Immune To Disruptions

The hearing aid market has been a pretty reliable grower over the last couple of decades, with the 2020 year being the first year of year-over-year contraction in at least two decades. Between an aging population, growing incidence of hearing damage, and improved perception around hearing aids (helped in part by performance and aesthetic improvements), this remains a market with steady growth potential – likely on the order of 4% to 5%.

While hearing aids are certainly not a classic example of a consumer discretionary purchase, there are discretionary elements to them. High-end devices can get expensive ($10,000 or more), and customers have the option of trading down for lower-featured devices (which can cost less than $1,000) or delaying a purchase altogether when budgets get tighter. I expect that that will be the case in 2023, and I do see some risk to Sonova seeing more trading-down and an adverse mix shift due to the macro environment.

A bigger disruption, and one that is harder to quantify, is coming from the FDA at long last finalizing rules in August of 2022 to allow for the sale of some hearing aids over the counter and without a prescription. The FDA has in effect created a new class of hearing aid meant for adults with “mild to moderate” hearing impairment, and under this rule there are already hearing aids available at retailers and pharmacies costing less than $1,000 (and less than $300 in some cases).

As I said, I think the impact of this new rule is hard to estimate. It’s certainly true that the core market Sonova addresses is the severe impairment market that was excluded in this new FDA rule, but I believe there are likely at least a few million people with hearing loss that would be considered borderline moderate to severe and may opt for these over-the-counter options. Likewise, I would expect some people with severe hearing loss to at least give the over-the-counter option a try given the price difference.

Longer term, I don’t think this rule change is going to profoundly hurt Sonova’s business. Competition in the hearing aid industry is based in large part on factors like aesthetics, sound processing, connectivity, available apps, and features like tinnitus masking, as well as add-ons like heart rate monitoring. Sonova has leveraged strong R&D and product development to gain share over the last decade, and I believe the differences between Sonova’s mainline offerings and the over-the-counter products will be stark. There are certainly many millions of people for whom the low-cost OTC options will be appropriate, but I doubt many of these were using Sonova’s core products and for those with more serious hearing loss, the “bargain basement” performance of these OTC options could drive more interest in Sonova’s better offerings.

Longer-Term Opportunities In New Markets

In addition to the manufacture of hearing aids, Sonova is also a major player in the operation of hearing care clinics. These locations can perform hearing loss-related tasks like testing/diagnostics, hearing aid fitting, and servicing, but they’re also expanding into other offerings like treatments for tinnitus. Sonova has less than half the number of clinics that Amplifon (OTCPK:AMFPY) has, but Sonova has been building up its presence in the U.S. (helped by the Alpaca deal) and has targeted China as a major growth market opportunity.

Sonova has also been looking for ancillary markets. The company acquired Sennheiser’s consumer audio business and is now offering “Consumer Hearing” products like headphones, earbuds, and soundbars. Other hearing aid manufacturers including Demant (WILYY) and GN Store (GNNDY) have made similar moves, and I’d argue it’s a logical extension of Sonova’s core R&D and technical capabilities. That said, the go-to-market strategies and marketing demands are considerably different, and I’m not expecting Sonova’s foray into consumer audio to be a major driver in the near term, but there could be worthwhile long-term potential in this business.

The Outlook

Acquisitions will help boost FY’23 revenue growth into the double-digits, but I do expect underlying core revenue growth to be softer in 2023-2024 on a weaker macro environment and disruptions from the availability of OTC hearing aids in the U.S. Over the next three to five years, though, I believe Sonova will see high single-digit revenue growth and growth in the neighborhood of 6% over the longer term. Sonova’s major opportunities are split between high-ASP, high-margin markets like the U.S. where growth is likely to be slower (but where there are still volume and share gains to be had) and markets like Brazil and China where penetration is low and growth potential is high, but where pricing will definitely be a challenge.

I’m expecting adjusted EBITDA margins in the low 30%s, rising toward the mid-30%s over the next five years. Working capital needs (inventory to offset supply chain risks) will interfere with free cash flow in the short term, but I believe Sonova can sustain mid-20%s FCF margins over time, driving 6% to 7% FCF growth.

Discounted free cash flow suggests a potential double-digit long-term annualized return from Sonova shares at today’s price. I also value med-techs by a matrix that uses revenue growth and EBITDA margin to drive a “fair” EV/revenue multiple, and by that approach I believe Sonova can/should trade at 4.6x to 4.7x forward sales, supporting a fair value more than 10% above today’s price.

The Bottom Line

The market has definitely not liked the uncertainties created by the weaker macro-outlook (with management acknowledging lower volumes of higher-margin products) and the new OTC hearing aid rule. While some concern is warranted and reasonable, I think the market has overcorrected and pushed this proven high-quality player into undervaluation. I do think sentiment could be challenging for at least the next six months, but this looks like a name worth performing due diligence on for readers looking to add med-tech exposure, and particularly European med-tech exposure.