William Demant Holding Industry: Health Care Equipment. Outlook and Investment Case. More than fully priced. Market Data. Highlights.

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1 William Demant Holding Industry: Health Care Equipment Outlook and Investment Case CBS Investment Team This report is published for educational purposes only by students competing in the CFA institute Global investment Research Challenge Rating SELL Price target (DKK): 371,0 Price, (DKK) 413,9 Downside (%) - 10,4 % Ticker WDH More than fully priced Highlights We believe that William Demant Holding (WDH) operates on a very attractive market and that the company will be able to maintain its high margins, and its ability to outgrow the market going forward. However, we base our SELL recommendation on the belief that the market price more than fully reflects the potential of the company. Drivers - Product launching and innovation drive market shares. The hearing aid industry is very attractive with only a few major competitors due to high entry barriers, making it unlikely that new major competitors will enter the market. In the hearing aid market, access to the distribution channels is essential and leads to the demand of a wide product portfolio. Market Data 52-week high (DKK): 479,5 52-week low (DKK): 350,5 Previous close (DKK): 408,0 Market cap (DKK m): Outstanding shares (m): 58,3 Float (%): 39,4 EPS (DKK): 13,6 P/E ratio: 29,6 Sources: Factset Growth in top line revenue and margins - Favorable development in demographics drives unit growth and provides the opportunity to deliver long term organic growth. From 2011 we expect the EBITDA margin to improve and return to historical levels around 24-25%. Our expectations for WDH are due to the visible long term demand, high barriers to entry and ongoing pricing power supported by continued technology innovation. Valuation - Our base case DCF valuation returns a target price of DKK 371, leading to a SELL recommendation on the share. The multiple analysis supports our view that the market has more than priced the value of the company. DKK WDH 52 week prices WDH 52 week prices Bear-Bull case spread 468,4 (+13,2%) 371,0 (-10,4%) 340,1 (-25,5%) Base case Downside risks: Failing to successfully introduce new products will reduce market shares. Increased pricing pressure from large retailers could limit margin expansion. Upside risks: Increased penetration of hearing aid or Government s intentions to provide more reimbursements for hearing aids would have a large impact to the whole industry in term of increased demand. Financial key figures FY09A FY10E FY11E FY12E FY13E FY14E FY19E Revenue (mdkk) EBITDA (mdkk) Net profit (mdkk) % ROIC 29,6% 28,2% 26,3% 27,8% 28,2% 28,2% 27,1% Invested capital (mdkk) P/E 27,2 22,5 20,4 16,9 15,2 14,0 11,1 EV/EBITDA 17,9 15,6 14,3 12,1 10,9 10,1 7,9 EPS (DKK) 13,6 16,5 18,2 21,9 24,4 26,4 33,5 Company Overview William Demant Holding A/S (WDH) engages in the development, manufacture and distribution of innovative and hightechnology solutions for hearing aids and communication of individuals. The company is divided into three business segments: Hearing Aids, Diagnostic Instruments and Personal Communication.

2 Business Description WDH is the second largest provider of hearing aid systems globally. WDH was founded in 1904, and is located in Denmark. The main shareholder is The Oticon Foundation with a majority share of 60%. Value chain WDH s core value chain consists of R&D, manufacturing, logistics and wholesale distribution. In the future the company expects to focus more on the retail area, which is characterized by high mark-ups. Strategy WDH aims to become the customers preferred supplier by maintaining a high innovation level and expand its global infrastructure. WDH uses acquisitions to capitalize on their technological and audiological expertise, managerial competencies and financial resources to create further growth. Products and regions WDH s core business is Hearing aids, but the company also operates within Diagnostic instruments as well as Personal Communication. WDH s largest brand is Oticon account for approximately 90% of hearing aid revenue, while Bernafon accounts for the remaining 10%. Each brand has its own product line consisting of several different hearing aids. Oticon s Agil was launched in March 2010 and is already the world s best selling high-end hearing aid. Europe is WDH largest market followed by North America. These two markets account for more than 80% of the company s sales. 11,00% 9,00% 7,00% 5,00% Figure 3: Market shares 7% 4% Siemens 22% William 11% Demant Sonova 13% 23% Source: Company data 22% GN ReSound Starkey Widex Figure 4: R&D expenses as % of revenue WDH Sonova GN Resound Source: Company data Industry Overview and Competitive Positioning Hearing aids is a very attractive industry with only a few major competitors The hearing aids industry has in the period undergone series of consolidations leading to the current state of market, which is best described as an oligarchy. The industry consists of only seven major competitors taking more than 90% of the total market, while the three largest players account for roughly 65%. In 2007 Sonova s acquisition of GN Resound in 2007 was prohibited by the German Federal Cartel Office, but the decision was later reversed by the Government Federal Supreme court on April It has opened the possibility for further consolidation of the industry. High entry barriers keep new competitors away The hearing aid industry has high entry barriers mainly due to high R&D costs, and this makes it unlikely that new major competitors enter the market. To operate in the hearing aid market access to the distribution channels (wholesales, retailers and national health services) is also essential. These demand a wide product portfolio which ensure the high entry barriers. 50% of all hearing aids sold are two years old or less, meaning that the hearing aid producers are forced to be innovative by developing new hearing aids with the latest technology to accommodate the short product cycles. Current competition: A R&D race This leads to an R&D race where the large companies obviously have an advantage. WDH has one of the highest R&D budgets in the industry and accordingly one of the best product portfolios. The launch of the first generation wireless hearing aid Epoc, led to a series of problems which resulted in a decrease in market share and increasing R&D expenses. Agil, the predecessor to Epoc, has proven itself as a top product. The question is whether the lower R&D expenses of Sonova as percentage of revenue is a signal of Sonova being more R&D efficient, or if we can expect WDH s R&D efficiency will improve in the future. We believe that WDH will remain competitive in the future in spite of their historical problems with Epoc, and that their R&D efficiency will improve slightly. However, it seems that Sonova is extraordinarily efficient at a level we find it unlikely that WDH will reach. The retail area provides investment opportunities for WDH WDH s core business accounts for a 20-30% share of the value chain s value, while the suppliers only absorb 4-7 % of the value. The main component in a hearing aid is the battery, but it only accounts for a 2

3 4-7% 20-30% Figure 5: Value Chain Component suppliers WDH core business 60-75% Retail Formula 1: Growth in first time buyers small part of the sales price. WDH posses a strong negotiation position against its main component supplier Pulse because its competitor Knowles Electronic offers the same products. The retail part area takes 60-75% of the value. The retail area has low entry barriers, because of no clear economics of scale, and it is characterized by a high degree of fragmentation. It is very difficult to create services of substantial value to end-users. The hearing aid market is continuing forward integration among several manufacturers, and a beginning consolidation is observed. The advantages related to the forward integration are control of distribution and additional growth through gain of market share in retail. The potential downside of the forward integration is collateral damage, as the manufacture will compete against its own customers. Beside that WDH has limited retail skills and as a consequence they can gain limited synergies. Drivers of unit growth within the industry High revenue growth expected in 2010 and 2011 The launch of Agil and the hearing aids industries recovering from the financial crisis will drive a high growth in revenues in 2010 and 2011 for WDH. WDH recently regained access to the Veterans Affairs (VA) in the US after being left out for several years. The VA accounts for a large part of the entire US market, but it is characterized by high volumes and lower prices. Sales from the re-entry to the VA market will contribute positively to WDH s growth rates in the short run. Drivers of the market growth The growth of the hearing aid market consists of: first time buyers and repurchases. We have estimated the yearly growth in first time buyers in the US and European market by multiplying the change in population, hearing loss, adoption rate and binaural rate. The growth in repurchases is estimated by: Population CAGR Europe North America Age ,11% 0,48% Age ,15% 0,22% Age 65+ 1,57% 2,60% Source: Euromonitor Life expectancy, years Europe 80,5 81,2 81,7 North America 79,9 80,5 81,0 Source: Euromonitor Hearing loss% Europe 2009 CAGR Age ,27% 0,00% Age ,95% 4,95% Age ,33% 1,90% Source: Marketrak, Eurotrak (year 2009) & our forecast Hearing loss% North America 2009 CAGR Age ,27% 1,60% Age ,95% 4,95% Age ,33% 1,90% Source: Marketrak, Eurotrak (year 2009) & our forecast We forecasted by three different age groups and consolidated the growth rates by markets. The consolidated numbers are multiplied by the year to year change in binaural rate to accout for the change in people that buy two instead of one hearing aid (Appendix: 4). Demographics as a strong driver in market growth The demographic development works in favor for the hearing aids producers as the population of older people is growing and the overall average age is increasing. The main reason for hearing loss prevalence is old age and thus a higher life expectancy will lead to a bigger market. Hearing aid prevalence expected to increase We see two contradictive tendencies: 1) Working conditions has improved in the western world and there is much more focus on working injuries e.g. working with machinery. 2) A potential increase in hearing aid prevalence coming from the ipod generation. Today it is very common to have an ipod even at a very young age. A lot of the headphones seal the ear, and make the potential for loud music causing hearing loss more significant. We expect a CAGR of 4,95% from 2010 to 2019 in hearing loss percentage in the age group years in both Europe and the US. Increase in adoption rate could make the market bloom A driver that could increase the market size significantly is the adoption rate, which refers to the percentage of people who suffers from hearing loss that actually bought a hearing aid instrument. Historic adoption rates, % US 23,8% 22,9% 22,6% 21,3% 20,4% 22,2% 23,2% 24,6% - Germany ,8% UK ,6% France ,8% Adoption rate CAGR Europe North America Age ,78% 0,78% Age ,70% 0,70% Age 65+ 0,56% 0,56% Source: Our forecast An interesting observation is that the adoption rate in the US has hardly changed during the last 20 years. According to MarkeTrak VIII this is mainly due to the stigma regarding hearing aids. Research has shown that 65% of the US hearing impaired population would decline the offer of a free hearing aid 3

4 instrument. The stigma has proven quite resilient. However, we believe in a slight increase in the adoption rates because of the hearing aids are getting smaller, better and cosmetically more appealing. A decrease in age of first time purchase could lead to higher growth rates The average age of a first time buyer in the US was 68,8 years in 2008 while the average age of first time users has fluctuated around age 66-69,7 during the last 20 years. The earlier the first hearing aid is bought the more products are sold per person during lifetime. We expect the average age to drop from 68,6 in 2010 to 66,8 in 2019, because of the higher quality of hearing aids. Beside that we expect the coming generations to be somewhat more open minded in terms of technology. Binarual population Europe US Population in ,0% 74,0% CAGR ,04% 0,10% Source: Markettrak, Eurotrak & our forecast Binaural rate could drive European growth Binaural rate refers to whether the customer wears one or two hearing aids. Comparing Europe with the US, the binaural rate is surprisingly low in Europe. The ability of two hearing aids working together to an extent where it gives the user a sense of distance and direction was not something hearing aids could offer until We believe that the benefit of having two hearing aids is greater now, and therefore we expect an increase in the binaural population in Europe. WDH s merger agreement with Otix Otix Global, Inc. designs, develops, manufactures, and markets digital hearing aids primarily to hearing impaired consumers. The company provides and sells its products to hearing care professionals and distributors. It operates in North America, Europe, and internationally. WDH has been in a hectic bidding war with GN Resound, where the buying offer was increased several times. Otix has announced that they will pursue a fusion with WDH, because GN Resound has informed they are not going to bid more. Otix s accepted bid was DKK 343m. Overall we see the acquisition of Otix as a positive strategic investment, due to expanding the product portfolio and growing its retail business in the US and Australia. We do not believe that the acquisition will change the market dynamics and balance of power significantly since Otix only accounts for roughly 1% of the world market share. Although the buying process has not been finalized we have integrated the acquisition in our valuation model, because we consider it unlikely to see any deal breakers at this point in the process. Investment summary The hearing aid industry is very attractive, because of the high entry barriers leading to high margins and the demographic development. The group of older people continuously grows and life expectancy is still getting higher, both ensuring a natural market growth. WDH has been through a tough period with product dysfunctions leading to high R&D expenses both absolute and relative to the industry. Now, WDH seems to be back on track with the launch of Agil, which has become a top selling product. We expect WDH to be able to maintain their high margins due to the before mentioned barriers, and the tendency within the business to forward integrate retailers, which should lead to an increase in price/mix. The question remains whether WDH will be able to run the retail part of the value as well as they have been able to run their core business. We expect WDH to be highly competitive going forward as a result of their focus on R&D and innovation. This is the main competitive driver in the industry due to short product cycles. We expect WDH to be able to slightly decrease their R&D/sales ratio in the future, but do not expect the company to achieve a ratio as low as the main competitor Sonova. We expect very high growth for WDH in 2010 and 2011 due to WDH reentering the Veterans Affairs market in the US and that the company is still recovering from the financial crisis. We also expect that the somewhat lower binaural rate of the European population could drive growth forward, as the rate is quite lower than the one observed in the US. Finally, the adoption rate could be a potential game changer, however stigma regarding hearing aids has proved persistent, and we find it unlikely to see big changes in adoption rates. 4

5 FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E CBS Investment Team, GIRC Financial Analysis Revenue by business segment Hearing Aids accounts for almost 90% of sales, which makes it the most important segment for WDH. WDH has already had a favorable development in the first half of 2010, foremost due to Agil, therefore we expect WDH to outmatch market growth by 12%, where 4% is due to a positive exchange impact. An improved hearing aid market outlook, a recently won contract with the VA, the launch of the new mid-priced hearing aid product Acto/Acto Pro and the new super-power device Chili provides the opportunity to deliver high growth. Therefore we expect the hearing aid segment to maintain revenue growth around 8-9% from The Diagnostic Instruments segment is forecasted to have moderate growth around the average of the previous 5 years, 11,4%. Personal communication is expected to have positive growth in revenue, after some years with negative growth. After 2010 we expect single digit growth around 4-5%. From the overall business growth expectations fade, and assume the long term growth, to be 2,6%. Revenue by business segment FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E Hearing Aids 5,061 5,964 6,641 7,257 7,884 8,550 9,192 9,802 10,383 10,958 11,243 % YY Growth 5.8% 17.8% 11.3% 9.3% 8.6% 8.4% 7.5% 6.6% 5.9% 5.5% 2.6% % Organic growth due to market exp. 3.8% 3.3% 3.8% 3.1% 2.9% 3.0% 2.6% 2.4% 2.5% 1.1% % Price growth 2.0% 2.0% 2.0% 2.0% 2.0% 1.5% 1.5% 1.5% 1.5% 1.5% % WDH premium 12.0% 6.0% 3.5% 3.5% 3.5% 3.0% 2.5% 2.0% 1.5% 0.0% Diagnostic instruments % YY Growth 18.7% 11.4% 11.4% 11.4% 11.4% 6.0% 6.0% 6.0% 3.0% 3.0% 2.5% Personal communication % YY Growth -6.2% 10.0% 5.0% 5.0% 4.0% 4.0% 3.0% 3.0% 2.0% 2.0% 2.0% Total Revenue 5,701 6,674 7,415 8,103 8,807 9,522 10,214 10,875 11,485 12,090 12,402 % YY Growth 6.1% 17.1% 11.1% 9.3% 8.7% 8.1% 7.3% 6.5% 5.6% 5.3% 2.6% Figure 6: Break of P&L Operating Profit The overall 2010 EBITDA margin is expected to grow. But due to the launch of Agil and the employee share ownership plan, the growth has not really set in during the first six month of From 2011 we expect the EBITDA margin to improve and in the long term we believe that WDH can return to historical levels around 24-25%. Our expectations are due to the visible long term demand caused by demographic changes, high entry barriers and ongoing pricing power, supported by continued technology innovation. WDH has the highest relative and absolute R&D spending, compared to the two other listed companies, Sonova and GN Resound, we expect the company to stay innovative during the coming years. Net Sales Gross Profit EBITDA NOPAT Cash Flow We have assumed the working capital, to be fairly stable going forward. Due to stable ratios but increased revenue, this will increase the money tied to operations. Working Capital FY08A FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E Receivables/Sales (days) 72,8 76,9 76,9 76,9 76,9 76,9 76,9 76,9 76,9 76,9 76,9 76,9 Inventory/Sales (days) 50,2 51,0 51,0 51,0 51,0 51,0 51,0 51,0 51,0 51,0 51,0 51,0 Other receivables/sales (days) 19,0 23,4 20,0 20,0 20,0 20,0 20,0 20,0 20,0 20,0 20,0 20,0 Other/sales (days) 4,5 6,1 6,1 6,1 6,1 6,1 6,1 6,1 6,1 6,1 6,1 6,1 Trade payables/sales (days) 14,9 14,2 14,2 14,2 14,2 14,2 14,2 14,2 14,2 14,2 14,2 14,2 Other payables/sales (days) 35,1 40,7 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 Prepayments and accrues/sales (days) 7,9 9,9 7,9 7,9 7,9 7,9 7,9 7,9 7,9 7,9 7,9 7,9 Other/sales (days) 10,1 9,4 9,4 9,4 9,4 9,4 9,4 9,4 9,4 9,4 9,4 9,4 Change in working capital

6 Capex WDH has announced that the current corporate investments in property, plant and equipment for 2010 are still estimated at DKK m. According to the company s own guidance, we expect the acquisition of Otix to cost around DKK 343m. There will be further investments around DKK 100m in 2010 through 2012 relating to a new domicile for Oticon in the US. Going forward capex is assumed to be higher relative to history, due to the expectation of further consolidation in the industry. Balance Sheet & Financing WDH has a debt/equity ratio close to 8%. Because of the Otix acquisition, we assume a less aggressive share buy back in The company has a net interest bearing debt target, between DKK m. We assume the target to be reached ultimo WDH currently has over capacity of approximately 15%, therefore the level of tangible assets is expected to decline from the current level. WACC components % Weight Risk free rate 2,6% Risk premium 6,7% Equity beta 0,95 Cost of Equity 8,9% 92,2% Lending premium 0,5% Cost of debt, pre-tax 2,6% Tax rate 25,0% Cost of debt, after-tax 2,3% 7,8% WACC 8,4% Valuation We value WDH using a DCF calculation. We have a forecasted period of 10 years ( ). Our base case equity valuation is DKK 371 per share, leading to a SELL recommendation. To support our DCF valuation we add a peer group multiple analysis. WACC The WACC is assumed to be 8,4%, based on a risk free rate of 2,6% (Danish 10 year government bond), risk market premium of 6,7%, an equity beta of 0.95 and a debt risk premium of 0,5%. The risk free rate is historical low and we do not believe this to be the "normal" level. The market risk premium is due to expected market return minus the risk free rate. We assume the return on the market portfolio to be rather stable, which currently leads to a higher than normal market risk premium. DCF-valuation We base our SELL recommendation on the following free cash flow statement. Cash flow statement (DKK m) FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E NOPAT Depreciation and amortisation Change in NWC: Operating cash flow CAPEX Capex % sales -3,4% -9,0% -6,8% -6,4% -5,3% -5,2% -4,9% -4,7% -4,4% -4,3% -3,5% FCFF t 0,5 1,5 2,5 3,5 4,5 5,5 6,5 7,5 8,5 PV(FCF) Valuation date 12-nov-2010 WACC 8,4% LTG 2,6% PV(FCF) Terminalvalue EV NIBD Equity 31/ Equity 12/ Number of shares, mio. 58,31 Target price 371 Price 12 th nov ,9 Upside/downside -10,4% 6

7 Multiple SENSITIVITY LTG WACC 1,6% 2,1% 2,6% 3,1% 3,6% 7,4% ,9% ,4% ,9% ,4% EV/EBITDA P/E 2009A 2010E 2009A 2010E WDH (estimated) 17,9 15,6 27,2 22,5 Market concensus Sensitivity analysis A sensitivity analysis with the WACC and LTG as variables shows how sensitive the share price is to only these two drivers. Holding WACC constant at 8,4%, and then looking at LTG, we find that only +/- 1% (our base case 2,6%), would change target price +16% and -11% respectively. This means that an increase in only +1% long term (3,6%), which is still in the range of WDH s own guidance, would result in the share being fair valued, and with a little to gain. Peer group multiple analysis As we expected GN Store Nord trades at other multiples than both WDH and Sonova. Sonova has the most comparable business model, and is therefore the best peer. At all market consensus multiples, WDH trades at premium compared to Sonova. According to our own estimates, WDH should be more in line with the multiples of Sonova, and therefore we believe that the market has more than priced the value of the company. WDH 19,2 15,2 29,6 22,9 Sonova 16,5 15,1 21,3 20,1 GN Store Nord 27,6 14,7-25,2 Budget control The historical ROIC shows the attractiveness of the business model, caused by high margins and low capital requirements. We believe that the ROIC will stay at a high level due to the entry barriers. In 2008 and 2009 the ROIC level has decreased, because of low margins and capitalization of goodwill. Though we forecast the NOPAT to return to historical levels, the tendency of capitalizing goodwill will continue as a consequence of the expected consolidation within the industry, keeping the asset turnover down. As a result the estimated ROIC stays around the 2009 level. Operation ratios FY06A FY07A FY08A FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E % ROIC 45,28% 40,2% 31,3% 29,6% 28,2% 26,3% 27,8% 28,2% 28,2% 28,1% 28,0% 27,8% 27,8% 27,1% % ROIC (excl intangibles) 47,83% 44,0% 36,0% 37,9% 39,6% 38,1% 41,0% 41,9% 41,9% 41,8% 41,6% 41,5% 41,5% 40,3% % Gross Profit 71,23% 72,1% 70,4% 71,8% 71,4% 71,0% 71,0% 71,0% 71,0% 71,0% 71,0% 71,0% 71,0% 70,5% % NOPAT 18,5% 16,6% 14,6% 15,2% 15,2% 14,9% 16,2% 16,5% 16,5% 16,5% 16,5% 16,5% 16,5% 16,2% Asset turnover 2,44 2,41 2,14 1,95 1,86 1,76 1,72 1,71 1,70 1,70 1,70 1,69 1,69 1,67 Asset turnover (excl intangibles) 2,58 2,64 2,47 2,49 2,61 2,55 2,54 2,54 2,54 2,53 2,53 2,52 2,52 2,49 Financing ratios % FGEAR 69,1% 82,1% 79,8% 59,6% 42,8% 28,0% 25,3% 23,3% 21,5% 20,1% 18,9% 17,9% 17,0% 16,6% % NBC -3,5% -4,6% -4,5% -3,3% -3,7% -4,0% -3,5% -3,5% -3,5% -3,5% -3,5% -3,5% -3,5% -3,5% % ROE 126,2% 163,1% 142,5% 86,7% 54,0% 38,8% 36,9% 36,4% 35,5% 34,7% 34,1% 33,5% 33,1% 31,6% Valuation ratios P/E 24,0 24,2 31,7 27,2 22,5 20,4 16,9 15,2 14,0 13,1 12,3 11,6 11,0 11,1 EV/EBITDA 16,7 17,6 19,7 17,9 15,6 14,3 12,1 10,9 10,1 9,4 8,9 8,4 8,0 7,9 EPS 15,4 15,3 11,7 13,6 16,5 18,2 21,9 24,4 26,4 28,3 30,2 31,9 33,6 33,6 Figure 7: ROIC Figure 8: Breakdown of ROIC 50% 40% 30% 20% 4,0 3,5 3,0 2,5 2,0 1,5 20% 18% 16% 14% 12% 10% % ROIC % ROIC (excl intangibles) Asset turnover Asset turnover (excl intangibles) % NOPAT 7

8 Investment risks Short-term risks Potential lack of strong product launches: If WDH does not successfully continue to execute new products launches, they will not be able to maintain or gain market shares. This is supported by the fact that 50% of sales in a single year are generated by product launches over the previous 24 months. Even though WDH launched the Agil wireless system with success, the predecessor Epoc signaled weakness in R&D efficiency. Pressure on margins: Large retailers are started to globalize and market conditions favor large-scale purchase. The large retailers and government markets put pressure on prices, which is a problem if WDH s R&D cost base continues to rise. WDH s exposure to UK s National Health Services (NHS) The UK accounts for 10% of WDH global revenues, and the NHS is its largest individual customer accounting for approximately 50% of the value of the UK business. The contract with NHS is currently under review, and that creates a risk that either the reimbursement terms are changed or more companies are given supplier status. Penetration of the VA market It is a risk that the penetration of the VA market potential is below WDH s expectations. Long-term risks Failure to meet product driven market: The market, in which WDH acts, is highly product driven. WDH s significant R&D initiatives help underpin their market position. In the long term it is vital for WDH to maintain an innovative edge and attract the most qualified and competent staff. Slowdown in hearing aid markets: An unexpected slowdown in one of WDH s major hearing aid markets as US or UK can make it difficult for WDH to maintain their growth rates and margins to cover their R&D spending. Potential consolidation: There is a possibility that one of the large players in the markets try to merge or make an acquisition of one the other players. Further consolidation in the market could be a risk for WDH in terms of losing its position as the second largest manufacture in the market. Stem cell research could lead to a pharmaceutical treatment of hearing loss: A future potential game-changer would be if the stem cell research would come up with a pharmaceutical or medical way to treat hearing loss. However, the researchers from Stanford and Harvard currently working on the research are nowhere close to coming up with something that could lead to such a treatment. This would, if it even is possible, happen in several decades from now. 8

9 Risk scenario simulations To test the potential impact of some of the risks, we have run our estimated impact of the risks through the model. Two of the scenarios are significant game-changers. If WDH fails to stay innovative it will lead to a decrease in our target by price by 40,8%. The magnitude of the impact is expected as the ability to be innovative is the main driver of the industry. The other game changing scenario is if an effective pharmaceutical treatment of hearing loss becomes available. This would only affect the long term growth, but the impact given that the treatment is effective and inexpensive could make it a very strong substitute to hearing aids. It should be noted however, that we find this scenario quite unlikely. Bear case Driver EBITDA-Margin R&D/Sales up to 9,4% from 2010 to perpetuity and Distribution costs/sales increase to 32% from 2011 to perpetuity leading to a long term EBITDA margin of 23,1 %. Long term growth Long term growth rate reduced to 2%. WDH premium Decrease in ability to outgrow market by 0,5% Asian growth rate - Adoption rate Adoption rate growth 0% from 2010 to perpetuity Binarual rate - Price target (DKK) 308,3 Up/down side -25,5% Implied EPS 2010E 16,2 Implied P/E 2010E 19,1 Bear and Bull case simulation Our scenario analysis is based on changes in the most significant value drivers and the changes impact on the stock price. Bear case: This scenario implies that WDH is not able to reduce its R&D/Sales ratio, which will account for 9,4% from 2010 to perpetuity. In addition to that their distribution cost efficiency decreases as a result of poor forward integration of retailers. EBITDA-margin decreases from 24% to 23,1% in the terminal period. Furthermore, long term growth is reduced to 2% (from 2,6% in base case). If WDH is unable to remain innovative, it is possible that its ability to outgrow the market decreases by 0,5%- points until continuing value. Lastly the stigma of hearing aid instruments results in zero growth in the adoption rate, while the binaural rate stays constant. The bear scenario gives a price target of DKK 308,3. Giving the stock a 25,5% downside to current price. 9

10 Bull Case Driver EBITDA-Margin R&D/Sales down to 7,5% from 2010 to perpetuity leading to a long term EBITDA margin of 26 %. Long term growth Increase in long term growth rate by 0,5% WDH premium Increase by 0,5% Asian growth rate Asian growth 8 % 2010 to 2018 Adoption rate Adoption rate among +65 growth increase to 2,5% in both Europe and US Binarual rate Increase to 2% growth Price target (DKK) 468,4 Up/down side 13,2% Implied EPS 2010E 18,0 Implied P/E 2010E 26,0 Bull case: In the Bull case we expect WDH to be able to improve its R&D efficiency from 2010 and going forward to 7,5% of sales, which is close to Sonova s R&D/Sales ratio. The long term EBITDA margin will reach 26%, while the long term market growth will increase by 0,5%-points compared to base scenario. Due to a better R&D than its competitors, WDH will outgrow the market by further 0,5%-point from Our base scenario is based on low expectations to market growth in Asia, but growth in this region could easily be as high as 8% per year in the forecasting period. Long term market growth stays at the same level as base case. In this scenario adoption rates among the oldest Europeans and Americans will increase on average by 2,5% per year instead of 0,6% from , because the stigma will be less outspoken as more people start to use hearing aids. Finally, hearing aid users in Europe with instruments on both ears will increase to a level close to the US market. It means that the European binaural rate from increases by further 1,5%- points per year compared to the base scenario. Price target is DKK 468,4 in this scenario, which means an 13,2% upside compared to the current stock price. Disclosures: Ownership and material conflicts of interest: The authors, or a member of their household, of this report do not hold a financial interest in the securities of this company. The authors, or a member of their household, of this report do not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the authors of this report is not based on investment banking revenue. Position as a officer or director: The authors, or a member of their household, do not serve as an officer, director or advisory board member of the subject company. Market making: The authors do not act as a market maker in the subject company s securities. Ratings guide: Banks rate companies as either a BUY, HOLD or SELL. A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater over the next twelve month period, and recommends that investors take a position above the security s weight in the S&P 500, or any other relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over the next twelve months. Investment Research Challenge and Global Investment Research Challenge Acknowledgement: The Danish Society of Financial Analysts Investment Research Challenge as part of the CFA Institute Global Investment Research Challenge is based on the Investment Research Challenge originally developed by the New York Society of Security Analysts. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the authors to be reliable, but the authors do not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with The Danish Society of Financial Analysts, CFA Institute or the Global Investment Research Challenge with regard to this company s stock. 10

11 Appendix 1: Profit and loss statement Profit & loss DKK m FY04A FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E Net sales COGS Gross Profit R&D Dist. costs Adm. expenses EBITDA Depreciations Amortisations EBIT Share of profit after tax, associates underta Exceptional gain and losses Non-operating gains and losses Financial income Financial expenses Net financial expenses EBT Tax on the year's profit Net profit

12 Appendix 2: Balance sheet Invested capital DKK m FY07A FY08A FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FINANCIALS Total equity Interest-bearing debt Net interest-bearing debt Invested capital OPERATIONS Intangible assets Property plant and equipment Intangible and tangible assets Trade receivables Inventories Other receivables Deffered tax assets Other Working capital assets Trade payables Other payables Prepayments and accrues income Other Working capital liabilities NWC Invested capital

13 Appendix 3: Cash flow statement Cash Flow statement DKK m FY09A FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E NOPAT Depreciation and amortisation Change in NWC: Operating cash flow CAPEX Capex % sales -3,4% -9,0% -6,8% -6,4% -5,3% -5,2% -4,9% -4,7% -4,4% -4,3% -3,5% FCFF Change in NIBD NFE after tax Non operating after tax FCFE Dividends and other shareholder transactions Liquidity surplus

14 Appendixes 4: Estimation of market growth Assumptions 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Growth binaural pop EU 1% 1% 1% 1% 1% 1% 1% 1% 1% 0% US 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Growth hearing impaired EU % 0% 0% 0% 0% 0% 0% 0% 0% 0% EU % 7% 7% 6% 5% 4% 3% 3% 3% 0% EU +65 2% 2% 2% 2% 2% 2% 2% 2% 2% 0% US % 1% 1% 2% 2% 2% 2% 2% 2% 0% US % 7% 7% 6% 5% 4% 3% 3% 3% 0% US +65 2% 2% 2% 2% 2% 2% 2% 2% 2% 0% Growth adoption rate EU % 1% 1% 1% 1% 1% 1% 1% 1% 0% EU % 1% 1% 1% 1% 1% 1% 1% 1% 0% EU +65 0% 1% 1% 1% 1% 1% 1% 1% 1% 0% US % 1% 1% 1% 1% 1% 1% 1% 1% 0% US % 1% 1% 1% 1% 1% 1% 1% 1% 0% US +65 0% 1% 1% 1% 1% 1% 1% 1% 1% 0% ASP Growth (incl inflation) EU 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% US 2% 2% 2% 2% 2% 2% 2% 2% 2% 2% Average age of first time users EU 68,8 68,6 68,4 68, ,8 67,6 67,4 67, ,8 US 68,8 68,8 68,6 68,4 68, ,8 67,6 67,4 67, ,8 Life Expectancy EU 7910% 7940% 79,7 79,8 80,2 80,3 80,5 80,6 80,8 80, ,2 81,3 81,4 81,6 81,7 US 7880% 7900% 79,3 79,4 79,6 79,7 79, ,2 80,3 80,4 80,5 80,7 80,8 80,9 81 Product replacement rate, years EU 4,1 4,15 4,2 4,25 4,3 4,35 4,4 4,45 4,5 4,55 4,6 US 4,1 4,15 4,2 4,25 4,3 4,35 4,4 4,45 4,5 4,55 4,6 First time owner in % EU 37% 37% 37% 37% 37% 37% 37% 37% 37% 37% US 37% 37% 37% 37% 37% 37% 37% 37% 37% 37% Estimated market growth (other markets) Pacific rim 4% 4% 4% 4% 4% 4% 4% 4% 3% 2% Asia 6% 6% 6% 6% 6% 6% 5% 5% 5% 4% Other countries 5% 5% 5% 5% 5% 5% 4% 4% 4% 3% 14

15 Hearing impaired % of population 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe Population Aged 0-14: January 1st 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% 2,27% Population Aged 15-64: January 1st 8,95% 9,58% 10,25% 10,97% 11,63% 12,21% 12,70% 13,08% 13,47% 13,87% 13,87% Population Aged 65+: January 1st 35,33% 36,04% 36,76% 37,50% 38,25% 39,01% 39,79% 40,59% 41,40% 42,23% 42,23% North America Population Aged 0-14: January 1st 2,27% 2,29% 2,32% 2,34% 2,39% 2,43% 2,48% 2,53% 2,58% 2,63% 2,63% Population Aged 15-64: January 1st 8,95% 9,58% 10,25% 10,96% 11,62% 12,20% 12,69% 13,07% 13,46% 13,87% 13,87% Population Aged 65+: January 1st 35,33% 36,04% 36,76% 37,49% 38,24% 39,01% 39,79% 40,58% 41,39% 42,22% 42,22% Adoption rate 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe Population Aged 0-14: January 1st 39,31% 39,62% 39,94% 40,26% 40,58% 40,90% 41,23% 41,56% 41,89% 42,23% 42,23% Population Aged 15-64: January 1st 24,07% 24,16% 24,28% 24,43% 24,60% 24,80% 24,99% 25,19% 25,40% 25,60% 25,60% Population Aged 65+: January 1st 42,79% 42,96% 43,17% 43,43% 43,69% 43,95% 44,22% 44,48% 44,75% 45,02% 45,02% North America Population Aged 0-14: January 1st 16,20% 16,33% 16,46% 16,59% 16,72% 16,86% 16,99% 17,13% 17,27% 17,40% 17,40% Population Aged 15-64: January 1st 13,63% 13,68% 13,75% 13,83% 13,93% 14,04% 14,15% 14,26% 14,38% 14,49% 14,49% Population Aged 65+: January 1st 29,91% 30,03% 30,18% 30,36% 30,54% 30,73% 30,91% 31,10% 31,28% 31,47% 31,47% Growth in hearing aids pr person 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe Avg First time buyer average age 68,80 68,60 68,40 68,20 68,00 67,80 67,60 67,40 67,20 67,00 66,80 Avg Expected lifetime 80,30 80,50 80,60 80,80 80,90 81,00 81,20 81,30 81,40 81,60 81,70 Avg product replacement, years 4,10 4,15 4,20 4,25 4,30 4,35 4,40 4,45 4,50 4,55 4,60 Products pr person 2,80 2,87 2,90 2,96 3,00 3,03 3,09 3,12 3,16 3,21 3,24 Growth 1 1,02 1,01 1,02 1,01 1,01 1,02 1,01 1,01 1,02 1,01 North America Avg First time buyer average age 68,80 68,60 68,40 68,20 68,00 67,80 67,60 67,40 67,20 67,00 66,80 Avg Expected lifetime of 70yo 79,70 79,90 80,00 80,20 80,30 80,40 80,50 80,70 80,80 80,90 81,00 Avg product replacement, years 4,10 4,15 4,20 4,25 4,30 4,35 4,40 4,45 4,50 4,55 4,60 Products pr person 2,66 2,72 2,76 2,82 2,86 2,90 2,93 2,99 3,02 3,05 3,09 Growth 1,00 1,02 1,01 1,02 1,01 1,01 1,01 1,02 1,01 1,01 1,01 Distribution within segments (split) 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe Population Aged 0-14: January 1st 18,02% 17,84% 17,69% 17,54% 17,43% 17,38% 17,29% 17,21% 17,12% 17,02% 16,92% 16,82% 16,72% 16,63% 16,57% 16,50% Population Aged 15-64: January 1st 66,43% 66,42% 66,43% 66,46% 66,47% 66,43% 66,33% 66,30% 66,15% 65,98% 65,81% 65,64% 65,47% 65,34% 65,18% 65,02% Population Aged 65+: January 1st 15,55% 15,74% 15,89% 16,00% 16,10% 16,19% 16,38% 16,50% 16,73% 17,00% 17,26% 17,54% 17,81% 18,03% 18,26% 18,47% Average 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% North America Population Aged 0-14: January 1st 20,46% 20,23% 20,03% 19,89% 19,78% 19,73% 19,69% 19,64% 19,62% 19,61% 19,61% 19,59% 19,54% 19,51% 19,48% 19,42% Population Aged 15-64: January 1st 67,09% 67,27% 67,41% 67,44% 67,36% 67,27% 67,19% 67,10% 66,74% 66,42% 66,11% 65,80% 65,53% 65,23% 64,92% 64,61% Population Aged 65+: January 1st 12,45% 12,50% 12,56% 12,67% 12,87% 13,00% 13,12% 13,26% 13,65% 13,97% 14,28% 14,61% 14,93% 15,26% 15,60% 15,97% Total 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 100,00% 15

16 Development in average sellling price 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E ASP ASP EU 1,00 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 ASP US 1,00 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 Forecasted growth in new users Index A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe Population Aged 0-14: January 1st 1 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,02 1,01 Population Aged 15-64: January 1st 1 1,09 1,09 1,09 1,08 1,07 1,06 1,05 1,05 1,05 1,01 Population Aged 65+: January 1st 1 1,05 1,05 1,06 1,06 1,06 1,06 1,06 1,05 1,05 1,03 Total 1 1,071 1,071 1,071 1,065 1,059 1,052 1,045 1,045 1,045 1,013 North America Population Aged 0-14: January 1st 1 1,02 1,02 1,02 1,04 1,04 1,04 1,03 1,03 1,03 1,00 Population Aged 15-64: January 1st 1 1,08 1,08 1,08 1,07 1,06 1,05 1,04 1,04 1,04 1,00 Population Aged 65+: January 1st 1 1,04 1,04 1,06 1,06 1,06 1,06 1,06 1,06 1,06 1,03 Total 1 1,066 1,066 1,066 1,062 1,056 1,049 1,043 1,043 1,042 1,008 Growth in repurchases 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E EU 1,00 1,02 1,01 1,02 1,01 1,01 1,02 1,01 1,01 1,02 1,01 US 1,00 1,02 1,01 1,02 1,01 1,01 1,01 1,02 1,01 1,01 1,01 Total market growth 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Weighted growth EU 1,000 1,040 1,034 1,039 1,031 1,029 1,031 1,023 1,023 1,027 1,011 US 1,000 1,039 1,033 1,038 1,031 1,029 1,026 1,028 1,023 1,022 1,009 Forecasted WDM revenue index A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Europe WDH Revenue, mio dkk WDH Revenue split 0 46% Revenue growth 6,08% 5,48% 6,00% 5,20% 4,95% 4,64% 3,87% 3,84% 4,26% 2,61% North America WDH Revenue, mio dkk WDH Revenue split 0 35% Revenue growth 6,02% 5,38% 5,92% 5,17% 4,91% 4,12% 4,33% 3,80% 3,77% 2,46% Pacific WDH Revenue split 0 8% Asia WDH Revenue split 0 7% Other countries WDH Revenue split 0 4% Consolidated revenue from hearing aids Year to year Growth 5,84% 5,35% 5,77% 5,15% 4,94% 4,52% 4,13% 3,93% 4,04% 2,60% WDM premium 12% 6% 3,5% 3,50% 3,50% 3,00% 2,50% 2,00% 1,50% 0,00% Total year to year growth 17,84% 11,35% 9,27% 8,65% 8,44% 7,52% 6,63% 5,93% 5,54% 2,60% 16