Sonova Barely Misses “Guidance;” Stock Tumbles 7% Despite Strong Fundamentals

Time to buy Sonova: Over-reacting to a sluggish European market, a slightly softer–than–expected earning report caused Sonova Holdings (SOON.S; SONVY ADR) to tumble as much as 8.3% from the previous close of CHF136.70 (US$138.45) to as low as $125.89, before recovering to $129.03 for the day. This was on the news of weak adult CI sales at their Advanced Bionics division, and losses to Costco’s Kirkland house brand, built primarily by GN ReSound and Wm Demant’s Bernafon.

Back–of–Envelope Analysis:

Although the AB and Costco reasons given are important, let’s look at the actual numbers: Sales in local currency rose 5.8 percent to 2.07 billion Swiss francs ($2.11 billion) in the company’s fiscal year to March, it said in a statement, behind Sonova’s 6-8 percent target. Constant currency earnings before interest, taxes and amortization (EBITA) rose US$6.18 million  (1.4%) to $436.1 million, compared to its 13–30 million (3-7%) goal. After-tax earnings were a bit soft at 349.5 million from $372.7 million in 2014/15, with this $23.2 million shortfall triggering a $600 million drop in market cap: Clearly an over–reaction, as the reasons given are only somewhat of a concern, and more importantly, easily fixable.

Sonova-stock-5-18-2016

From Reuters:

Braunschweiler’s new guidance for 2016/17 — sales growth of 4-6 percent and EBITA expansion of 3-7 percent — was described as “weak” by Berenberg analysts, who listed customer disenchantment with Sonova’s retail acquisition strategy, recession-plagued Brazil and problems at Costco among the company’s main woes.

“Costco is a concern, as this had been a key growth driver and Sonova appears to be losing ground to the new own-brand,” Berenberg’s Tom Jones wrote in a note.

Braunschweiler said that prices for Costco’s Kirkland-branded hearing aids were recently cut by a further $200 to $1,800. Sonova’s Phonak Brio model at Costco can cost hundreds more.

Even so, Braunschweiler said that Sonova cannot abandon supplying hearing aids through Costco because margins from those transactions exceed those of Sonova’s other U.S. retail outlets.

“We have to be a part of this channel because it is growing,” Braunschweiler said. “But there’s the question of how we position our products, and there are ongoing discussions with Costco about how we’ll do this.”

What caused the analysts to panic:

The Costco losses to Kirkland Signature devices built by GN ReSound & Wm Demant are somewhat troubling, but importantly, they don’t seem to track with sales to the VA. However, this can be addressed by introducing lower cost devices into the Brio line: Remember, they are selling to UK’s NHS tender for about $100 per aid, so there is plenty of room to move on price. What’s more, when it comes to Bluetooth 4.0 connectivity, although GN ReSound sells their 1st generation LiNX x62 RIC device in Costco, we do not recommend it due to the high drain on the too-small #312 cell (the 2nd generation LiNX² x62 RIC uses a #13 cell, and doesn’t have this problem). We also know Sonova has their next-generation Roger “Moore’s Law” radio chip ready to roll out: If they indeed put this in their Costco aids, it will be a game-changer in that channel.

The Advanced Bionics situation is somewhat different, as besides currency fluctuations, it is also subject to the taxation and productivity–sapping regulatory vagaries of not only the United States, but also the State of California… And the elections in six months will signal which way the winds will blow. Although we see headwinds from the Golden State, a Trump victory will see a radical policy shift to an export-based manufacturing economy, including some devaluing of the Dollar. What’s more, from our extensive social media observations we see the reason why adult sales are weak: Lack of integral Bluetooth radios in their speech processors, which we pointed out in October 2014 …and Med-El and GN licensee Cochlear now sport. We strongly believe adult sales will climb faster than expected once they start producing Bluetooth-equipped speech processors.

Why we are Bullish on Sonova:

First off, Sonova has an ace in the hole vis-a-vis Costco: Their Connect Hearing stores. Although they aim for “traditional” hearing aid selling prices, we also know they have a “nobody walks” policy, where they will actually beat Costco pricing. Speaking as someone who has “worked in the trenches,” having that sales tool works wonders (and is also when people who can’t afford hearing aids write to us, depending on the circumstances, we often refer them to a Connect location for this very reason). Because of this, any lost Brio unit sales can be partially offset by increased Connect volume: There are only a finite number of hearing aid purchasers in any given area, so changes in volume in the Costco channel don’t occur in a vacuum.

The US$953 million AudioNova “strategic” purchase two weeks ago was interesting. Doing our same “back–of–envelope” calculations as we did yesterday of GN Store Nord’s acquisition of Audigy, we see with an annual volume of 300,000 devices sold at 1300 stores, this totals out to $733,000 to buy each store which sells on average 230 aids/year (~20 HA’s/month). Another way of looking at this is that they paid $3170/device sold every year. Did Sonova overpay for AudioNova? Probably. But the market already baked this acquisition into the cake. Whether today’s plunge is an over-correction for general market conditions, or simply the market catching up to the AudioNova acquisition is something we don’t know. However, the stock did indeed rise 4% at the time, so perhaps it was due for a correction.

Two other observations: As we mentioned, AB is in the LA Basin subject to California’s “sunshine taxes;” but also Unitron’s & Phonak’s operations are in the high-cost states of Minnesota and Illinois. Two years ago, your humble editor lived in Naperville, within walking distance of Phonak’s Warrenville headquarters. Although the manufacturing & repair areas looked good, I was struck by the overhead, which comes right off the bottom line. Time will tell if their second expansion to nearby Aurora in 2½ years will lower their overhead and logistics costs, so they are addressing this issue.

The second observation is that, over the years, Phonak has cultivated audiology students, getting them “hooked” while still in school, i.e. “you dispense what you learn.” The payoff is in the pediatric space, not only with hearing aids, but also in their FM line: Roger has a hammerlock on the US educational audiology market for this very reason. GN ReSound has stepped up their game with the new Multi Mic, which unlike the earlier Mini Mic is now suitable for school use. However, to this day ReSound stubbornly will not introduce their UP Smart pediatric versions of the LiNX & Enzo to the North American market, so the pediatric market here will remain with Sonova’s Phonak and Demant’s Oticon divisions as the big players.

Summary:

At the end of the day, we believe the 7% drop in Sonova stock is an overcorrection, despite what we believe as them overpaying for AudioNova two weeks ago. Especially if you have dividend reinvestment of the SOON.S or SONVY shares in your 401(k), watch for quiet acquisitions by the plan administrators at this lower price to give you a small bonus, as when we look at the underlying fundamentals, we expect the stock to rebound.

Bootnotes:

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About the author

Dan Schwartz

Electrical Engineer, via Georgia Tech

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