Hearing Aids Legislation Bodes Well For Sonova

| About: Sonova Holding (SONVF)

Summary

Recent U.S. legislation signals big changes for hearing aids industry.

Established companies and start ups to battle for over the counter market share.

Sonova Holding AG with its efficient R&D programs will likely prevail.

Introduction

I had an engaging conversation with an audiologist during a holiday potluck and boy did I get, pardon the pun, an earful! Heretofore I never thought about hearing aids, much less the companies that make them. But after learning about incredible technologies that can reduce wind noise for hearing impaired patients who drive convertibles or provide a seamless connection between TV viewers’ hearing aids and their favorite shows, well, I had to look into this industry.

According to a November 2017 Research-and-Markets report in PR Newswire, the global hearing aids market is projected to reach $9.78B by 2022 from $6.97B in 2017, at a CAGR of 7.0%.” Noisy work and living environments and an aging population are the reasons behind the growth. Worldwide, 1.3 billion people suffer from hearing loss. The Hearing Loss Association of America states about 20 percent of Americans--48 million--report some degree of hearing loss. At age 65, one out of three people has a hearing loss.

The "Big 3"

The hearing aids market is dominated by three big publicly traded players , Sonova Holding AG (Switzerland), William Demant Holding A/S (Denmark), and GN Store Nord (Denmark). Other privately held players include Starkey Hearing Technologies and Widex

Denmark’s GN Group (OTCPK:GGNDF) develops and markets Beltone, Interon and Resound hearing aids. They also produce wireless headphones for a range of customers that include music enthusiasts and call center operators under the Jabra brand. The Swiss firm, Sonova (OTCPK:SONVY), is the world’s leading manufacturer and developer of hearing instruments, operating through three distinct and complementary brands. Phonak is the industry’s leader in technologically-advanced hearing aids and wireless communication products. Other brands under the Sonova umbrella are Unitron and Hansaton. Cochlear implants represents a second reporting segment. Another Danish company, William Demant (OTCPK:WILLF), also develops, manufactures and sells hearing instruments, hearing implants, diagnostic instruments and personal communication devices. Their brands include Oticon, Bernafon and Sonic. Implants are also among their offerings.

Public health and audiology experts report the big firms benefit from economies of scale and often hold exclusive relationships with medical practitioners. These factors in turn provide a significant competitive advantage and high barriers to entry. Little wonder why hearing aids are expensive (as much as $6000 for a pair) and aren’t covered by most insurance plans. Indeed, only 1 in 7 of those 48 million Americans with hearing loss use hearing aids.

Fundamentals

Tables 1 and 2 below highlight key profitability, growth and financial health metrics. Noteworthy is the 13% return on total capital (includes equity and bond holders) that they all enjoy--an indication of their wide moats. Debt levels while elevated are manageable.

Ticker

NI/Sales

Sales/Assets

Assets/

Equity

ROE

Return on Total Capital

Gross Profit Margin

Operating Profit Margin

GGNDF

0.122

0.82

2.35

0.235

0.137

0.63

0.16

SONVY

0.145

0.66

1.84

0.176

0.130

0.72

0.17

WILLF

0.128

0.82

2.22

0.233

0.130

0.76

0.17

Table 1 –“Big 3” Profitability

Ticker

Debt/Equity

Operating Profit/Debt

Long Term Debt/ Net Income

Current Ratio

Interest Coverage

GGNDF

0.69

0.42

3.1

1.46

24.64

SONVY

0.35

0.54

2.03

1.84

242.5

WILLF

0.27

0.39

1.23

0.85

29.85

Table 2 - "Big 3" Financial Health

Relative Valuations

Relative valuation is a bit of a mixed bag as indicated in Table 3 below. About all that one can clearly discern is that the Big Three’s relative TTM PE valuation looks attractive compared to the medical device industry at large.

Ticker

P/B

P/B

5 Yr Avg

Forward

P/E

TTM P/E

P/E TTM 5 Yr Avg

P/CF

P/CF 5 yr avg

P/S

P/S 5 yr avg

GGNDF

5.6

3.4

26.5

25.9

30.1

15

18.5

3.1

2.8

SONVY

4.7

4.7

25.9

27.6

34.1

19.2

20.5

4

4.2

WILLF

6.4

6.2

22.6

29.2

23.3

25.7

21.2

3.7

3.2

Medical Device Industry Avg

3.7



41.7


24.6


4.3


S&P 500 avg

3.1



22.7


14.2


2.2


Table 3 - Big 3 Valuations

Big Changes Coming to the Industry

A shakeup, however, is coming to the hearing aids industry which will produce new winners and losers. A few months ago, the President signed into law the Over-the-Counter Hearing Aid Act which when implemented by the FDA, will enable people with mild (difficulty in hearing soft speech or sounds such as a babbling brook) to moderate (difficulty hearing conversations amid background noise or the hum of a motor) hearing loss to buy directly over the counter Personal Sound Amplification Products (PSAPs) costing just a few hundred dollars. The FDA will have thee years to develop regulations and specifications to which manufacturers will have to produce.

To be sure, the Big 3 will continue to maintain their competitive advantage in the lucrative hearing aids market for those with who suffer more severe forms of hearing loss (estimated to be about 27% of the world’s 1.6 billion hearing impaired population) and can afford the devices. The legislation, however, opens the door for smaller, nimble companies to compete with the Big 3 in selling (albeit at reduced profit margins), PSAPs.

Privately held Etymotic Research’s co-founder, Mead Killion, who has long led the charge for this legislation and is one of many smaller companies poised to compete in this new “OTC Market”. Among his products are devices for users ranging from orchestra musicians to infantry troops that dampen loud noises but keep audible music or conversation respectively. Meanwhile a Swiss startup—Fennex-- is well underway toward marketing a replacement to the hearing aid with a pair of wireless earbuds and a smartphone app. One can easily imagine Bose and a raft of others gearing up to get in on the act. Those who use their R&D dollars the most effectively will likely prevail.

Two metrics are useful for evaluating research and development efficiency—Return on Research Capital (RORC) and % of R&D to Revenue. RORC is computed by taking current year’s gross profit and dividing it by the previous year’s R&D program. Higher is better. It provides a quick look at the how many dollars of gross profit is generated by each dollar of R&D spent previously. R&D to revenue is expressed as a %. Lower is better. Since the Big 3 are European companies that report under IFRS rules, they can expense and capitalize R&D.


RORC Latest

RORC Yr 2

RORC Yr 1

3 Yr Avg RORC

% R&D to Sales Latest

% R&D to Sales Yr 2

% R&D to Sales Yr 1

3 Yr Avg % R&D to Sales

GGNDF Gross Profit

8651

7755

7340

7915

8651

8404

7340

8131.6

Expensed R&D

707

623

545

625

707

623

545

625

Capitalized R&D

481

411

349

413.6

481

411

349

0.127

GGNDF RORC

7.28

7.5

8.21

7.62

0.13

0.12

0.12

0.07

SONVY

Gross Profit

1652

1375

1388

1471.6

2396

2072

2035

2167.6

Expensed

R&D

114

96

150

120

114

96

150

120

Capitalized R&D

16

35

0

17

16

35

0

17

SONVY

RORC

12.7

10.49

9.25

10.74

0.054

0.06

0.07

0.063

WILLF Gross Profit

9030

7895

6813

7912.6

12002

10665

9346

10671

Expensed R&D

763

680

664

702.3

763

680

664

702.3

Capitalized R&D

0

0

0

0

0

0

0

0

WILLF RORC

11.8

11.61

10.26

11.26

0.063

0.0637

0.07

0.065

Table 4 – "Big 3" R&D Efficiency

SONVY’s latest RORC of 12.7 shines compared to its competitors and represents a 37% improvement from two years ago. While SONVY’s three-year average % of R&D to revenue barely bests the other two, its latest shows a 14% improvement from two years ago.

Recommendation

Investors interested in medical device companies should set their sights on the hearing aid provider SONVY given their R&D efficiency and three other factors. SONVY’s economies of scale suggest they will be able to hold their own against smaller and newer companies looking to get in on a piece of the PSAP action. Moreover, the company has years of data from clinical trials involving hearing loss that would likely be relevant to PSAP development.

Thirdly, their long-established brands provide another advantage. Think for a moment about someone you know who is in their 60’s or 70s who wants to buy a PSAP for their hearing problem. Would these older folks be more inclined to buy from a mature company with years of clinical trial documentation in hearing loss or a start up company whose customers are hipsters who use the ear pods to listen to indie music?

SONVY ADR is down almost 4% since July 2017 when Congress began to quickly move the legislation forward and almost 13% from its 52-week high. The stock’s 5-year range of $20.60-$36.20 gives it a midpoint of $28.40 which is about 10% less than the ADR recent selling price of $31.50. Add another 5% for a greater margin of safety and investors may want to buy in at roughly $26.75.

Be careful, however, when buying the ADR. Average daily volume is about 14,000 which could mean a wide bid/ask spread. Be patient and use limit orders in an effort to buy for slightly less than the U.S. equivalent of the stocks previous closing on it home exchange.

Summary

Recent legislation will bring big changes to the hearing aids industry and pit the "Big 3" companies with a raft of newer ones for market share of PSAPs. Those who can execute their R&D programs effectively will likely prevail. SONVY, in my, opinion will be a winner.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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