GNNDY - Sonova In A Growth And Margin Leverage Gully But Valuation Makes It Worth Watching

2023-10-06 07:30:00 ET

Summary

• Sonova has experienced a greater than expected hit to market share in the hearing aid market due to the loss of a major retail customer and price-driven market share loss.
• Sonova's margin performance has likewise come up short, leading to estimate cuts from sell-side analysts.
• There are opportunities for Sonova to regain momentum through new product offerings, expansion in China, and leveraging AI and machine learning technology in its high-end hearing aid business.
• Mid single-digit revenue growth and roughly 400bp of long-term FCF margin improvement can support worthwhile upside from here, but the near term is clouded by underwhelming growth and margin leverage.

It's been a tougher run of late for Sonova (SONVY) (SONVF) (SOON.SW) than I'd expected roughly a year ago. While there was a near-term hit to industry volumes, those volumes have since recovered for other players in the hearing aid market and Sonova has seen a greater than expected hit to market share from the loss of a major retail customer in the U.S. as well as more straightforward price-driven market share loss. At the same time, margin performance has been rather lackluster.

Sonova shares are down about 15% since my last update (the ADRs have done a little better), roughly double the decline of the broader medical device space. Demant (DEMANT.CO) has been significantly stronger, helped by strong share growth in North America, while Amplifon (AMFPF)(AMP.MI) has likewise had a lackluster run and GN Store Nord (GNNDY)(GN.CO) has been even weaker.

I do see a risk of below-consensus performance when Sonova reports fiscal first half results next month, and while I do think management can deliver on the stronger second half results they've already guided for, I think this has become a "show me" story with respect to maintaining/rebuilding market share and continuing to deliver on market leverage. I can argue that the shares are undervalued on long-term free cash flow, but I do think it will take visibility on better sales growth and margin leverage to get investors really interested again.

Competitive Offerings And Price Driving Some Share Loss

As the leading player in the market (with somewhere around 30% share) and one with a focus on the high end of the market, Sonova has the challenge of maintaining share against more aggressive up-and-comers in the market. That effort was not helped by the loss of its contract with Costco (COST), a situation that has provided a definite boost to Demant (and GN Store, to some extent) in the U.S. market.

Sonova has also made the decision to try to maintain a more aggressive pricing strategy, arguing that the product performance advantages of new products like Lumity can and should support premium pricing. While some rivals have used Sonova's move as "cover" to raise their own prices, Sonova has put itself in the position of being the high-cost provider in a market where out-of-pocket spending can be a significant factor (and in markets like Germany where a major insurer is trying to push out an upgrade cycle to manage costs).

With all of that, the company has lost a few percentage points (300bp-400bp, I estimate) of share over the last 12-18 months. Add in that underlying unit volume growth has started to slow in North America, and it's not a great set-up for the company's financial reports.

I would expect around 2% to 3% organic growth for Sonova in that upcoming F1H'24 report, and while the calendar periods don't line up like-for-like, that's going to look poor next to the 24% organic growth in hearing aid revenue at Demant, the 17% growth at Ampifon, and the 15% growth at GN Store. Remember, though, that the year-over-year comparison is hurt by the loss of Costco (which also benefits Demant and GN Store), so while it's not good, it's also not that bad.

Opportunities To Regain Some Momentum

I do see some opportunities for Sonova to generate better results over the next 24 months or so, and executing on these opportunities will certainly be important for the share price performance.

In that prior article on Sonova I talked about some incremental risk to Sonova's business from the FDA allowing over-the-counter sales of hearing aids; while Sonova's business is up-market from what is allowed to be sold OTC, it could still drive some incremental share loss (and perhaps has played a role in the recent share losses).

Looking to offset this potential risk and participate in what could be a worthwhile market opportunity, Sonova is leveraging its Sennheiser consumer business acquisition (from 2022) to enter this market while not sacrificing or comprising its high-end Phonak brand. The new Sennheiser All-Day Clear has gotten generally solid reviews so far and could become a meaningful product over time.

Sonova is also still looking to drive growth through its audiological care business and its second-largest base of locations around the world (Amplifon is the leader). While the core of this business will remain in areas like hearing diagnostics, fitting, and service for hearing aids, opportunities like tinnitus treatment still over upside.

Last and not least is expansion potential in the core business. China remains a growth market for Sonova, though one where getting pricing right and establishing a durable advantage over local players could prove challenging. I do also see expansion/growth potential from the company's strong R&D capabilities. Management is looking to leverage AI and machine learning to improve its speech recognition capabilities, and given the idiosyncratic nature of hearing loss (it's not far off to say that every person's hearing loss is slightly different) improved onboard software that can fine tune to a user's particular needs could be an important share driver.

The Outlook

I don't have good explanations for the margin weakness (FY'23 EBITDA margin was about six points short of expectations) other than the cost inflation we've heard about from almost every company and perhaps a tendency for analysts to get out too far ahead of their skies to justify higher estimates and fair values. I do think we'll see an improvement in the second half of this fiscal year, but 30%-plus EBITDA margin is looking further off than I expected a year ago.

I'd also note one potential additional risk factor to the long-term outlook - the entry of EssilorLuxottica (ESLOY) into the hearing market after the acquisition Nuance Hearing (which uses acoustic beamforming technology). EssilorLuxottica believes the hearing market lends itself to its strengths (product development and product design in a market where users perceive a stigma), and I wouldn't underestimate the company. That said, a lot of EssilorLuxottica's growth can be tied to M&A and lax antitrust enforcement, and I don't think growth-by-M&A will be as easy now in the hearing aid market.

I'm expecting pretty lackluster revenue growth this year (quite possibly none on a reported basis), but I do still believe that mid-single-digit long-term growth is possible. With the changes to my model, my like-for-like long-term revenue growth number moves from a little over 6% to around 5%, but as I said above, I do see opportunities for Sonova to regain share and participate in growing the market.

On the margin side, I want to see better execution below the gross margin line. I understand the need to invest in the business (R&D and sales), and I likewise understand that higher labor costs are a fact of life, but margin leverage is an important part of the story. I've cut back my expectations to mid-20%'s EBITDA margins for the next couple of years, though I think better execution could get that into the high-20%'s in three years. On the free cash flow side I've ratcheted down my expectations over the next three years, but I still think a mid-20%'s long-term FCF margin (versus a long-term trailing average of a little over 19%) is attainable, and that would drive a high single-digit FCF growth rate.

I get two very different fair value ranges based on my two different approaches to valuing med-tech stocks. Free cash flow suggests as much as 20% near-term undervaluation, while margin and growth-driven EV/rev suggests far less upside (in the 5% to 10%). It's a reality that med-tech stocks often trade on near-term revenue growth and EBITDA margin prospects, and neither are looking great for Sonova right now.

The Bottom Line

I think there's an argument here for patient long-term value investors to take a look at what Sonova offers. The problem is that the main drivers of med-tech stock performance (short-term growth and margin leverage) won't likely be in effect for the next 6 months and maybe not for the next 12-18 months. I do see a risk of these shares becoming a value trap (and I don't rule out the risk of further share loss), but I think there are particular drivers of the near-term weakness (the loss of Costco, et al) that will fade and I think this is a value name to consider if you can afford to be patient.

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