Investors may not be too familiar yet with innovative hearing aid manufacturer Eargo (NASDAQ:EAR) -- the upstart only went public in October. But it has been listening well to its customers, and folks in search of new stocks to buy in the healthcare sector will want to take note.

Eargo reported crystal-clear first-quarter earnings on May 12, with 74% net revenue growth. System shipments (with a "system" being two hearing aids, a charging case, and starter accessories) were up by 66.5% year over year to 11,704 for the quarter. The company hopes to keep the momentum going with the launch of its next-generation product, the Eargo 5, in the back half of 2021.

person sitting. shell to ear.

IMAGE SOURCE: GETTY IMAGES.

Decreased returns are juicing margins

Listening to its customers has proven fruitful for Eargo, as the company has continued to reduce its product return rate -- a key metric in this niche. In Q1 2020, that return rate was a hefty 28.2%. Cutting it to 23.2% in Q1 2021 helped propel its non-GAAP gross margins to 72.2%, up from 63.2% in the prior-year quarter and 70.8% for Q4 2020.

With a sequential improvement in the return rate (which was 24.2% in Q4 2020), Eargo is headed in the right direction. Since the hearing aid industry overall has a return rate in the high teens, there may be even more room for Eargo to improve here. If this $1.3 billion market cap company could achieve industry-average return rates, its margins would likely be industry-leading: Hearing aid juggernaut Sonova Holding (OTC:SONV.Y) operates with a 72.3% gross profit margin.

Eargo also turned up the volume on guidance. Citing continued sales volume growth and stable return rates and selling prices, it raised the low end of its 2021 net revenue guidance range from $87 million to $89 million, keeping the top end steady at $93 million. Despite this, the stock fell 16% on the day after its earnings release.

New product, same great price

Eargo has carefully crafted its vertical integration and a strong customer experience model for this year's new product launch. Consumers interested in its Eargo 5 system will be able to schedule remote appointments with the company's licensed hearing professionals before purchase, allowing them to receive clinical support and hearing screenings from their own homes. Not only that, but customers will be able to gauge their hearing in real time outside an audio booth. This will also allow immediate device calibration while the device is in the ear canal.

The company is maintaining a high level of engagement with customers after the initial purchase in its efforts to provide an outstanding experience and build brand loyalty. And while one might expect that this higher-touch model would require it to raise its prices, the Eargo 5 will be priced similarly to the company's previous offerings.

Management has high hopes that its new system and enhanced customer service approach will attract consumers who might otherwise not have purchased hearing aids at all. Currently, only 27% of U.S. adults who have hearing loss own a hearing aid, so there's a large unaddressed market out there to target.

Despite these good intentions, the decision not to charge a premium for the Eargo 5 was a sticking point for analysts during the earnings call Q&A. A few seemed genuinely puzzled by the strategy. The market may have shared that puzzlement, which may at least partially explain the stock's plunge the day after the earnings release.

Conservatively sizing up the competition

On the conference call, Eargo management readily acknowledged that the company is operating in a highly competitive space. Rival Listenlively has a similar setup to Eargo, offering devices at similar prices and online audiology appointments. Sonova is the worldwide leader in hearing solutions with just under $3 billion in annual sales. Bose certainly has brand recognition in the U.S., and hear.com is an online marketplace for hearing aids. Despite this, the company believes that its vertically integrated model is a key differentiator, and that it offers a unique value proposition to customers.

"We feel very good about having opportunity to meet and exceed our guidance for 2021," said Chief Financial Officer Adam Laponis during the conference call. I tend to believe management's upbeat outlook here, since Eargo has grown revenue 74% year over year through the pandemic. By comparison, Sonova's U.S. sales fell 10.8% in 2020.

Management was rather cautious with its guidance on gross margins, predicting that they would land in the 68% to 71% range this year, despite reaching 72% in the first quarter. Perhaps the C-suite is leaving some wiggle room for increased returns when the Eargo 5 debuts, but current estimates seem like a setup for future earnings beats.

This upstart has already run circles around the competition during the pandemic. With its revenue estimates increasing and a new product launch coming up, Eargo is a company that healthcare investors may want to add to their watch lists.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.