Sonic: The Sound of Potential

04/25/2003 12:00 am EST

Focus:

George Gilder

Founder and President, Gilder Publishing, LLC

"One contrarian possibility for investing is to look for real, undiscovered technology, unrecognized value, or a nascent franchise," say analysts Andrew Redleaf and Richard Vigilante, who publish the Technology Market Advisor along with George Gilder. "What about a technology that can do more for less? We may have found one." Here, the advisors look at a company that is looking to change the market for hearing aids.

 

Sonic Innovations (SNCI NASDAQ) credibly claims to have the best hearing aids on the market. Its technology is derived from Caltech physicist Carver Mead’s multi-decade-long research in improving the correspondence between electronic sensory devices and their human analogs. Readers of the Gilder Technology Report have long known that Mead has arguably done more than any man living to advance microelectronics over the past 50 years.

 

“Hearing aids have been primitive devices that routinely disappoint new users who expect lifelike results. They were always too loud because vowels were needlessly amplified and consonants were not pumped up enough.  This problem was solved by a company called ReSound in 1990; at the time Andrew Raguskus, now CEO of Sonic, was vice-president of operations for ReSound.  Digital devices were introduced in 1997, yet at up to $7,000 each they still fell short of expectations. Finally, Mead and a team of researchers at Brigham Young began the development what has become the core of Sonic’s product line. Its systems can discriminate between human speech and suppress outside noise. They have crammed 9 frequency bands into a very small digital signal processor (DSP) programmed to allow for multi-banding and dynamic range compression.

 

“The core problem for the industry explains CEO Raguskus is the way that hearing aids are sold.  The way to understand hearing aid sales is to think of optometry 30 years ago when you could only buy eyeglasses from an ‘optometrist’ with a box and a few dozen ugly frames.  In the hearing aid business today ‘audiologists’ play the same role.  In this environment, competition is muted and markups are very large, often 200%.  That’s one reason only an estimated 20% of people who could be helped by hearing aids use them. Over time, the introduction of more digital devices should tend to disrupt this retail model; as chips decline in size and prices decline, and there is more of a shift to in-the-ear models we expect a move toward a consolidated retail model like today’s retail optical industry. Sonic made its first product just four years ago but already commands 8% of the digital market. The firm has been addressing the distribution problem through its own sales force. Abroad, the company has been buying distributors, which tends to enhance gross margins and raise the company’s profile with retailers. In Australia, the company went all the way and bought a retail chain. Australia is one of the firm’s fastest growing regions and its most profitable.

 

“So why is the stock so cheap?  To begin with, it IPO’d at a silly season high of $22 just as the bubble was about to burst. Within a few months it lost 75% of its value, branding it as one of ‘those’ stocks in the minds of tech investors. Nevertheless, the company has shown strong sales growth and the stock has fought back. It has been as low as $2 and above $5. Gross margins rose from 45.4% in 2002 to 52.1% in 2002 and 53% for the fourth quarter.  First Albany expects the firm to make continued progress towards 60% margins. The real margin breakthrough should come from the Adesso line, which fits completely within not just the ear, but the ear canal. First Albany expects a 47% increase in Adesso sales.

 

“So what’s the stock worth? It recently traded as low as $2 a share. The balance sheet is ‘lovely, if petite’ with a current ratio over three, a quick ratio over 23, no long-term debt,  and $30 million in cash and equivalents.  Translation:  the firm is here to stay. Replacement value is probably closer to triple than double current market cap. Translation: plenty of downside protection. The company is not profitable yet but our bet is that it will be. If the stock eventually sold at two times enterprise value it would trade at $8.50 to $9.  However, we expect to wait for a bigger bang, looking for a full valuation of four to five times enterprise value.  Long term, this stock could be a ten-bagger, trading in the 20s.”

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