Description

For ease of use I am writing about the Swiss company listed in CHF and not the USD ADR (unfortunately Swiss wasn't an option on the country drop down menu so to make it less weird I put the ADR).  So the numbers above in the financials part are in CHF.     

Sonova Holding AG ("SOON") is a swiss based hearing aid company.  They are the largest hearing aid company in the world and compete with other behemoths like William Demant, Siemens, GN ReSound, Starkey, and others.  As with all great pitches, I shall attempt to start this with a pithy one liner (please pardon the bad pun and if you think of better puns please submit them in the comment section) that summarizes my thinking along with the colorful infographic below of SOON's newest product which will be rolled out in 2016 (yes if you are wondering it does work with both Android and iOS phones):  

"SOON is deafeningly expensive; and I have a hard time hearing the value".

Preliminary Thesis: SOON is overvalued.  Their technology is trailing the market and they are poorly positioned going forward.  The hearing aid market faces increasing competition (from new technology) and profitability faces secular headwinds (channel shift as additional competition undercuts the traditionally highly profitable distribution medium).

The sell side consensus is projecting that SOON will continue to grow (re-accelerating  growth) as SOON launches new products (regaining market share lost to competitors) and SOON will take out additional costs expanding their operating margin. SOON historically traded at a premium to EU Med Tech due to higher growth & margins.  Additionally, the market is excited about the potential rollout with Walgreens (note nothing is actually announced and Walgreens doesn't even have opticians in their locations let alone the requisite audiologists required to replicate the Alliance Boots rollout in the EU, so suffice it to say this is years away from reality, if ever). 

Company Overview:

The hearing aid wholesale market is $5B/year market with around 10M units sold.  The crystal ball viewers are projecting 2% to 4% forward volume growth.  The cochlear implant market is $1B and growing 8%/year.  SOON is the largest global manufacturer of hearing aids and cochlear implants.  SOON’s hearing aids (the Phonak and Unitron brands) represent 90% of revenue (cochlear implants are 10% of revenue) and hearing aids are 100% of profits (cochlear implants are breakeven).  EMEA is 41% of sales and USA is 37% (in the U.S. the veterans affairs hospital system represents 7% of SOON’s total sales).  SOON has ~2,200 of their own retail locations, including a partnership with Boots in Europe to distribute products in-store.  SOON has struggled to grow lately as their new products have stumbled (for some inexplicable reason they refuse to release products with modern day technologies and abilities to synch with logical devices like iPhones etc. Their competitors are not so sheepish and as a result they have been taking substantial share (GN ReSound and Starkey for example). GN ReSound has been stomping SOON in the market as they have cutting edge products that work with today's technologies and as a result consumers are shifting in mass to them.  SOON’s topline hasn’t grown too much since 2010 and their margins have actually contracted since then from 27% to 20.7% today.  SOON has also been bleeding share of the VA market in the  U.S. (the VA market represents about 20% of all hearing aid units sold in the U.S. so this is a hugely important statistic), in 2013 they had 54% of the market and as of March 2015 they were down to 42% and this continues to march lower.  It is painfully obvious that SOON has their head stuck in the sand as the market evolves around them.  SOON’s management has taken to cost cutting initiatives and made some acquisitions to right this sad state but they remain stuck with tepid growth and declining margins (to further my amazement their multiple has actually expanded throughout this process – go QE go!). 

Hearing Aid Market Dynamics:

1.       Hearing aids are prohibitively expensive (mid-level pair of aids costs ~$4,400) and are facing pricing pressure: channel (wholesale, etc.) and new technology – PSAPs cost 1/10 the cost (PSAPs currently lack FDA approval – despite little evidence showing why they are inferior – as a result a growing number of people use them (1.5M in the US currently).

2.       Hearing aids are not covered by Medicare, Medicaid covers hearing aids (differs state by state) & VA covers the costs of hearing aids and is 22% of the US hearing aid market.

3.       Two out of three Americans with self-reported hearing difficulty do not wear hearing aids. Most common reason cited – price.

Just for fun let’s go through the broken math of the hearing aid market.  You could purchase two Phonak Audeo V90 hearing aids or for the same price you could get four 128GB iPad Air 2 with Wifi & Cellular and four Bose Quiet 25 Comfort noise cancelling headphones and you would still have money left over to purchase two SoundWorld CS50+ PSAPs to help correct your hearing maladies.  This is just a whiff of what is wrong with the hearing aid market and how technology, more competitive distribution, and a more informed consumer will start to erode the excessive profits the space has been achieving.     

At this point you are probably saying what is a PSAP? Instead of me writing a lengthy piece describing what PSAPs are I encourage you to read many of the fine academic pieces out there put out by various audiologists.  For those too lazy who just want a cliffnotes version here is a nice BusinessWeek Article that basically does the same job: http://www.bloomberg.com/news/articles/2015-03-05/hearing-aid-alternatives-get-cheaper-more-powerful

I have spoken with a number of audiologists as well as some users of hearing aids (even sent some of my more aged family members in as test dummies to various places to confirm some of my suspicions).  The key thing you need to know, most folks who need hearing aids don’t buy them.  Those who do often are misinformed and easily go with what is recommended by their local audiologist (audiologists have preferred brands they work for and get kickbacks from – so yea this like most medical technology is somewhat of an icky market).  PSAPs are good for most but not all cases of hearing aids.  They currently lack FDA approval but as they take a bigger share of the market this will change.  I am by no means saying that PSAPs are right for everyone as true hearing problems need a specialized audiologist and a customized design, but for the bulk of people a PSAP will do the job.   Unlike the PSAPs of old (exhibit A: https://www.youtube.com/watch?v=111OMKCNM4w) the market has advanced dramatically (exhibit B: http://www.npr.org/sections/health-shots/2013/07/02/197639536/to-make-hearing-aids-affordable-firm-turns-on-bluetooth) and folks are now more aggressively using them.  The market for PSAPs will grow rapidly as their technology is more user friendly (app enabled, tethered to electronics, etc.) and they cost literally 1/10 the cost of a hearing aid so it is an easy way to dip your toe in the enhanced hearing market.       

The perfect case study on this market is the commoditization of ophthalmic lenses in the 90s.  For those with long enough memories as Walmart, Lenscrafters, and other low cost retailers entered the space the small specialty shops could not compete with rationally low pricing and retail prices were pushed lower.  This is exactly what will happen with hearing aids only the key difference is hearing aid companies own a huge portion of the retail channel and mark up their products by 3x or more.  SOON owns independent resellers like HearingPlanet, Lyric, and Epic.  The gross margins at the retail channel are around 80% versus 40%-50% at wholesale chains like Costco.  This also speaks nothing of the inevitable competition they could face from online competition (someone will crack how to go to an audiologist in person and order online at some point).  Speaking of Costco, they entered the market in 2004 and in the past ten years went from 0% market share to 10% of the US market (they are also taking something like 80% of the growth in the commercial market).  Costco’s preferred partner is GN ReSound (this is what they use for their Kirkland Signature brand) and this contract was reaffirmed in Feb’15 (worth noting that Costco obviously sells multiple providers but clearly pushes GN ReSound harder than others as its their preferred partner).  As Costco and other mass market retailers enter the market it will put pressure on SOON’s highest margin channel resulting in margin degradation.   In 2004 66% of SOON’s sales came from their higher margin channels (owned retail and wholesale independent) as of 2013 this has shrunk to 60%), I expect this to shrink to below 50% in the not too distant future due to increased wholesale chains entering the market and other new competitors. 

Conclusion:

So what do all these forces result in?  SOON will face declining margins and slowing growth and as the market realizes this and witnesses continued declining EPS and FCF the multiple will collapse (instead of expanding like it has in the face of poor results look at EEG charges for EPS and revenue and slowly feel your jaw drop) and the price will drop 30%+ in the face of this.  SOON currently trades at 25x forward earnings despite only 5% projected EPS growth.  The sell side is banking on 2017 and beyond being the time when growth magically reappears in the topline and margins expand (note there is literally no evidence to support this).  Bulls are hanging their hat on things that won’t materialize anytime soon (Walgreen’s rollout and cochlear implant profitability) and are ignoring the huge risks: channel shift impacting margins, competition continuing to take market share, and the impact of new technologies (PSAP, etc.).  As the poor economic reality confronts investors the stock will react commensurate and will drop.  Why should a business with low single digit topline and low single digit EPS growth trade for 25x earnings (this is not a fantastic business – it is fairly commoditized in fact and the only thing supporting margins are excessive prices insurers are paying (this will end with wholesale competition, superior competitive products from folks like GN ReSound and others, and PSAPs) and the fact that the majority of sales are going through high margin channels (high margin channels are 2x to 3x the margins of the areas that are actually growing – this will result in lower forward margins due to channel shift).  

The key question this leaves me with is: If a stock falls in Europe and no one is around to hear it, does it make a sound?

Catalyst

Channel shift and increasing competition is resulting in declining margins coupled with tepid topline growth.  These mediocre results will eventually result in multiple compressions which will collapse a richly priced stock.  This is a replay of the commoditization of the opthalmic lense market in the 1990s.