Sonova's hearing eclipsed

When we last teased about Sonova in September 2018, the world’s No.1 hearing aids manufacturer’s first generation Made-for-All/MFA product (offers iPhone and Android connectivity) was struggling to find traction. If that was not enough, the US FDA approval for Bose’s ‘self-fitted' hearing aid, which disrupted the industry’s decades-long oligopoly, made matters worse.

However, the tides turned favourable thereafter as Sonova’s R&D engine produced a game-changing MFA product, Marvel (launched in November 2018) – robust demand for the product led to an acceleration in sales in H2 18/19 and H1 19/20 and two guidance upgrades for FY19/20. Interestingly, the Swiss firm has outpaced its Danish peers in sales terms (Sonova: +10% during September 2018-2019 vs. GN Store Nord: +c.8% and Demant: +c.5%) and the same has been reflected in the share price (refer chart below). Unfortunately, a sell-off in global equities due the outbreak of COVID-19 has taken away some sheen recently – Sonova has one manufacturing plant and c.1% sales exposure to China.

While Sonova’s business model remains sturdy with a superior profitability profile and the lowest gearing ratio amongst hearing aids rivals, the best of the top-line growth might be behind. The FY19/20 targets signal a deceleration in sales in H2 19/20 and, in our view, new product launches by rivals could play spoilsport. With the upcoming OTC regulations in the US (effective 2020) also a threat to the retail business, Sonova is best left untouched for now. Its share price obviously reflected more major broad market concerns of late so that the upside is a solid 19% at the time of writing.

Marvel-lous wholesale…

As Marvel addressed the shortcomings of the first-gen MFA product and included additional functionalities as well, Sonova’s wholesale business (c.53% of sales) recorded double-digit organic sales growth in H1 19/20, a first in a decade. Interestingly, the product’s best-in-class rechargeable feature also enabled the Swiss firm to reclaim the top spot (c.51% share in January 2020) in the US Veteran Affairs channel (c.20% of the US hearing aids market). Undoubtedly, Marvel has been the company’s most successful launch ever – sold >1,000,000 units within ten months of launch (previous best took twelve months).

…could run out of steam  

In the c.CHF6bn hearing aids wholesale arena where the product lifecycle is shortening, a stock is as good as the next product. With the GN Google partnership, Marvel has lost its Android connectivity USP and as competition intensifies in the rechargeable category – Sivantos’ recently-introduced Xperience platform is performing well and Demant’s Opn S is getting back in shape (following resolution of cyber-attack issues) – Marvel could lose pace. Whether Sonova’s newly-introduced earbud look-a-like hearing aid, to tap an additional market of audiophiles, could make up for the shortfall remains to be seen.

Retail gains ground…  

Benefiting from the network streamlining carried out in the US and the Netherlands, Sonova’s retail operations (c.38% of sales) witnessed a step-up in sales in H1 19/20 (+6.9% vs. H2 18/19: +5.5%). Going forward, centralised lead generation management and improved in-store execution should translate into robust same-store growth. Combined with M&A, to strengthen the omni-channel presence, the retail business is set to outgrow the wholesale business in the mid-term (sales growth target of +6-8% in retail vs. +3-5% for wholesale).  

…but OTC a risk  

Sonova’s inorganically-built retail business (it has the largest network amongst the wholesalers) could be challenged in the OTC era. The entry of Bose has opened a window of opportunity for other non-medical players, with experience in audio, to enter the arena. Also, as lower-priced products would dominate the market, where the costly support services (like testing and adjustments) would cease to exist, prices could come under severe pressure. Ergo, the dynamics of the c.CHF10.5bn hearing aids retail market are set to change. CVS, one of the largest pharmacy chains in the US, sensed the potential disruption to the value chain early and decided to shut all (c.50) of its hearing centres.

Note that increasing the focus on the margin-dilutive retail business has weighed on Sonova’s return matrices significantly – ROCE down from 25.8% in FY08/09 vs. 11.1% in FY18/19 – and any deviation from the vertical-integration strategy could put the mid-term financial targets at risk (Sonova targets c.1% sales growth pa from bolt-on).

Valuations

Unfortunately, the exciting top-line growth witnessed in the past few quarters has come at a price: H1 19/20 profits missed estimates due to higher marketing and R&D spend. As these investments are necessary to stay resilient for the future, earnings momentum could also slowdown in H2 19/20 – EBITA guidance implies a sequential deceleration. The OTC regulation also caps mid-term margin expansion potential. Ergo, both our intrinsic valuation metrics throw a downside. The attractive shareholder rewards (c.40% dividend pay-out and buy-backs before cancellation of buy-backs on 16/03), is also challenged. Still Sonova is one of those must-haves that recently joined our Buy & Hold Portfolio.