William Demant – from now on simply Demant – has served us well as co-owners. After a successful executive succession, in which the “heir” is familiar with the company, the culture and the industry, we have confidence in him continuing to grow the company. There are plenty of opportunities. Just consider the fact, that only every fifth American who should currently be using a hearing aid actually has one.

Hearing problems are only seldom discussed when talking about health issues, but there is a huge unmet need for hearing aids around the world. People’s hearing typically diminishes with age, and as life expectancies are projected to increase, time is on Demant’s side.

Demant managed to win market shares in 2018 with strong and ground-breaking innovation. The issues on hearing problems have been researched very thoroughly in the United States, and while 48 million people have impaired hearing, only 20 percent of those who should be using a hearing aid actually have one. The proportion of the population with hearing problems who are using a hearing aid has been slowly growing as well. For those above the age of 70, the proportion has grown from just over 25 percent in 2001 to more than 30 percent in 2012, and the authorities in the United States want this proportion to further increase.

At the same time, research has revealed that the loss of hearing increases dramatically with age. As hearing loss is expected to impact 30 percent of Americans between 65 and 74, and 47 percent of Americans over the age of 74, this creates attractive opportunities for the manufacturers of hearing aids.

The numbers from the United States are presumably the same for the rest of the world by and large. Based on the demographic trends in which the elderly population is rapidly growing, the potential market for hearing aids will also be growing. The demographic trends are expected to support quite predictable annual growth of four-to-six percent in the number of hearing aids sold. On top of that, the correlation of the number of hearing aids sold to economic upswings and downturns has historically been quite low.

Historically, there have been six global players on the hearing aid market, and Demant, also known as Oticon, is one of them. In 2018, two of the other manufacturers, Danish Widex and German Sivantos (formerly a part of Siemens) announced that they would be merging, and with a secured approval in 2019 from the competition authorities, the six manufacturers became five.

We are confident that Demant celebrated the day that their competitors were granted permission to merge – a more consolidated industry should be positive for the potential value creation of the industry as a whole. For the other four companies, it is also an advantage that previous mergers in the industry have resulted in negative sales synergies, meaning the merging companies ended up losing market shares in the process.

Avoids the downward pressure on prices that other sectors are suffering under

Demant, together with the Swiss company Sonova and the now-merged Widex and Sivantos, are in a dominant position on the hearing aid market, each having a market share of just under 25 percent. The market for hearing aids is a global niche market, and the five largest companies control more than 95 percent of it. The economies of scale are significant in the hearing aid industry, and the market-leading manufacturers are thus in the best position to achieving the highest levels of profitability.

In the start of the 1990s Demant was weighed down by financial problems but has now become a Danish high-tech export success and they have also created significant value for its shareholders since it was listed on the stock exchange. For many years, this was accomplished under the former CEO, Niels Jacobsen, who helped create the foundation for a strong, value-focused and forward-thinking culture, and this work has been continued under the current CEO, Søren Nielsen.

Hearing aids are paid for by the public healthcare systems in a few North European markets. In most global markets, the purchases of hearing aids are much more likely to be financed by the consumers themselves. Thus, the market for hearing aids is not subject to the same pressure to reduce prices from public authorities as seen in other areas of medical technology.

For Demant, however, there has been a gradual and persistent change in sales channels. It has gone from only selling hearing aids to audiology clinics to increasingly selling them via the American membership-based low-cost chain store, Costco, while at the same time a number of capital chain buying clinics have also made widespread acquisitions of clinics. This has resulted in a minor downwards pressure on prices on an annual basis. Demant and the other manufacturers of hearing aids get the highest sales prices by selling to independent clinics, though abovementioned dynamics and the manufacturers’ own acquisitions and integration of hearing aid chains has decreased the share of sales to independents.

In both 2017 and 2018, Demant has, however, seen a slight improvement in its average sales prices due to new product launches and a small shift in sales channels, due to innovation encouraging the users to look for the more expensive products. As a result, the average sales prices have increased by five-to-six percent in each of the past two years.

This has been driven by Demant’s launch of the innovative product Oticon Opn, which has been a great success, and the strong sales momentum from the launch has lasted significantly longer than what has been seen with previous high-end product launches. We see this as an indication of the strong audiological technology that Opn is based on. In 2018, Demant grew its wholesale business organically by nine percent in a market that is estimated to grow by less than four percent and significant market shares has thus been gained.

Need for a change in the United States and Australia

With Oticon Opn, Demant has also increased its market share on the American market targeting sales to war veterans, the Veteran Affairs, a segment in which Demant was previously underrepresented in. With the market share having grown from 11 percent in 2016 to almost 20 percent by the end of 2018, this is a clear demonstration of how Opn is having a significant positive effect on Demant. It is also worth mentioning in this context that the American market was the strongest growing segment of Demant’s wholesale business in 2018.

With the launch of Opn S in the spring of 2019, it is assessed that Demant will once again be able to grow at higher rates, as the Opn paradigm has ensured that the group will have the leading audiological technology in its hearing aids – something which the competitors have not yet been able to match.

For several years, Demant and the other market leader, Sonova, grew their business by acquiring audiology clinics in order to increase the sales growth of their own hearing aids. For example, Demant acquired the French chain Audika in the autumn of 2015 and thus acquired 460 clinics and annual revenues of around 100 million Euro.

The integration of Audika has been going well, even if Demant’s own clinics as a whole did not perform satisfactorily in 2018 with disappointing sales growth of 1 percent – Audika, however, delivered a satisfactory result. This lower organic growth was due to the American and Australian markets experiencing negative organic growth. We see no indications of structural problems on the big markets for company-owned clinics in the United States and Australia, and with increased management attention and already launched initiatives, we are confident that this development will be turned around.

When acquiring audiology clinics, Demant and other manufacturers can increase the proportion of their own products that are sold. Before the acquisition of Audika, Demant’s products represented around 30 percent of Audika’s sales – today, it is more than 80 percent. The operating costs of a clinic are practically fixed, and a reduction in revenue thus has a significant impact on the profit margin. Conversely, however, there are significant economies of scale and operational leverage that can be taken advantage of when the products sold change to your own in combination with increasing revenue.

Besides the sales through their own clinics and wholesale, Demant has two other divisions, Medical and Diagnostic Instruments, which respectively amount to four and nine percent of revenue, in addition to the associated Sennheiser.

Revenue growth in Medical decreased in 2018 to an organic growth of five percent, which was negatively impacted by the lack of new product launches in the bone-anchored hearing aids that make up half of Medical’s revenue. However, with the launch of a new bone-anchored implant, Ponto, in 2019, momentum is expected to return to the business which is basically a duopoly – Demant holds around 30 percent of the market share currently while the rest is held by the Australian company Cochlear. We see no reason why Demant should not be able to capture half of this market.

Neuro 2 – a product to take note of

Medical’s hearing aid implant business has significant brand value, R&D and Group synergies, and the hearing implant market is growing by 10-12 percent, which is significantly faster than the general market for hearing aids. The market for hearing implants is much larger than the market for bone-anchored hearing solutions. Medical’s market share on the hearing implant market is still modest at around three percent, but the launch of Neuro 2 is expected to strengthen Demant’s market position. It will be a boost for the implants when the current tender contract in low-price countries expire.

Demant will instead focus its Neuro 2 sales efforts on markets with higher sales prices until the manufacturing has been streamlined and the production costs per unit reach a level where it is once again considered worth the effort to sell on low-price markets. We expect Neuro 2 to have more momentum in 2019.

Market shares are only slowly won on the implant market, where clinics are cautious in trying new solutions. However, Demant has seen a fortunate expansion in the number of clinics that surgically attach implants, and it is gaining a stronger foothold among the leading clinics in Germany. This is not, something that will be accomplished overnight. Neuro 2 is not approved on neither the American nor Chinese market, which are the two biggest markets for implants. The approval process takes time, but Demant is working towards being able to enter these two markets as well.

Medical is expected to achieve higher gross profit margins in the long run with a clear potential to achieve higher levels of profitability than the existing hearing aid business. The market has vast potential in a five-to-seven-year time frame.

Over the ensuing five years, Oticon Medical is expected to be able to achieve a level of profitability that at least matches Demant’s traditional hearing aid business, and perhaps exceeds it, as sales and market shares grow. Oticon Medical is assessed as being supportive of stronger earnings and growth in the Demant Group. Oticon Medical’s revenue was at 509 million Danish kroner in 2018, equivalent to less than 4 percent of total revenue.

The last division in the group is the previously mentioned Diagnostic Instruments, which is a duopoly between Demant and the American Natus. In 2018, Diagnostic Instruments had impressive organic sales growth of 12 percent in a market that is only growing by 5 percent. We expect that Demant will be able to maintain a decent growth rate and conquer new market share in this area.

An improvement to the profit margins had been expected

In 2018, Demant had revenue of just under 14 billion kroner, which was a six percent increase compared to the year before – and organic growth was 7 percent, but currency fluctuations had a negative effect on the reported revenue. The organic growth was driven by wholesale and Diagnostics Instruments.

Demant has intensified its focus on taking advantage of the company’s resources and economies of scale, and it managed to decrease the cost base by 200 million kroner from 2016 to 2018.  This corresponded to almost 1.5 percent of revenue and thus increase the earnings-ability. There should be plenty of good opportunities to increase the profitability by taking advantage of the economies of scale of the group in particular within the company owned audiology clinics. Demant has further focused on increasing the manufacturing efficiency of the hearing aid by centralising the manufacturing and development in the more cost-efficient Poland.

Operating income grew by eight percent in 2018, while the operating margin remaining steady at 19 percent, which is an increase of 1.5 percentage points over a two-year period. We were surprised that Demant did not manage to improve its operating margins in 2018, but we do recognise that this was due to a disappointing development in the retail clinics in the United States and Australia and the fact that management increased its investments in R&D by 12 percent, and thus increased the R&D-to-sales ratio. The R&D investments amount to one billion kroner, equivalent of more than seven percent of revenue. Medical remains in an investment phase where the heavy investments weigh the results and water down the margin for all of Demant by one percentage point, as it operates at a loss of 125-150 million kroner.

However, we appreciate our companies have the courage and financial strength to make long-term investments, even if these have a negative impact on the short-term reported earnings – we know that these short-term dips are not a full reflection of the company’s ability to generate earnings. We view it as an indication of a strong corporate culture and a highly skilled management team that the focus is maintained on maximising the long-term value creation potential and not on satisfying the stock market’s focus on short-term developments in margins.

Management at Demant has been very stable. Previously the company was headed by number cruncher, Niels Jacobsen, for almost 20 years, who was the longest serving CEO in the Danish large-cap index C20 when he stepped down in April 2017. He was followed by CEO Søren Nielsen, who has also been with Demant for more than two decades and been a part of the executive management since 2015. The results from Søren Nielsen’s first years at the helm have been good, and with his commitment, enthusiasm and laser-sharp focus, we are convinced that he will continue to reward us as co-owners.

Several benefits from economies of scale lie ahead

The continuity in the company is also ensured by the election of Niels Jacobsen as the deputy chairman of Demant’s board of directors, and his new role as CEO of the company’s main shareholder, William Demant Invest. At the annual general meeting in 2018, Niels B. Christiansen, CEO of LEGO, was elected chairman of the board, replacing the former CEO of Falck, Lars Nørby Johansen.

Besides Søren Nielsen, the executive board includes CFO René Schneider. René Schneider is assessed as having made significant positive contributions to several of the company’s efficiency projects that helped streamline the group and increase the profitability.

As we see it, Demant can increase its operating margin significantly from the 2018 level of 19 percent. Demant has previously managed had higher margins but the operating margin has been negatively impacted by the shift to lower-margin distribution channels, including company owned audiology clinics, and the significant long-term investments made in developing Medical.

If growth in revenue continues – as it did in 2017 and 2018 –this will add greater benefits of economies of scale and make the company more competitive, which in turn will create the foundation for improving operating margins. Like the development of Medical, a continued streamlining of both the retail and manufacturing parts of the business will also have a positive impact.

The amount of debt Demant holds is limited, amounting to barely six billion kroner – equivalent to two years of EBITDA. Demant does not distribute dividends, but instead uses any excess cash to buy back shares. In 2019, it is expected that 1.2 billion kroner will be spent on buying back shares equivalent to 2.5 percent of the market value.

In the first half of 2019, Demant will launch the next phase of the Opn family, Opn S, and it has more product launches on the way for both implants and bone-anchored hearing aids, which should result in Medical getting back on track towards revenue growth of 25 percent due to the expected growing market shares in this fast-growing segment. We therefore believe that Demant is in a strong position to win more market share.

There remain significant opportunities left to exploit on the market for hearing aids, and with the fortunate consolidation of the market to five main players, the market situation is healthier and the profit potential should have grown as well. In any case, we can trust that Demant will not overhear the needs of those with impaired hearing.