Demant A/S

CSE:DEMANT

Earnings Call Analysis

Record EBIT Amidst Upbeat H1 Results and Resilient Growth

In the first half of the year, the company witnessed a strong surge, with organic growth of 13% and EBIT soaring to a record high of nearly DKK 2 billion, representing a stellar 27% growth. The group's margin improved by 1.4 percentage points, benefiting from significant operating leverage in the Hearing Healthcare business, where a robust cash flow of DKK 1.8 billion was also observed. These outstanding figures led to an optimistic revision of the full year outlook, with organic growth expectations elevated from 6-10% to 11-14%, and EBIT forecasts raised from DKK 3.8-4.2 billion to DKK 4-4.4 billion. Despite adverse exchange rates causing a 1.3% decline in gross margins, the company experienced elevated demand across its Hearing Care and Diagnostics segments, countered by a disappointing performance in the Communication sector. Sustainability milestones are equally noteworthy, with the approval of science-based CO2e emissions reduction targets, a renewable energy share hitting 22%, and increases in gender diversity enriching management across the board.

First Half Performance and Market Dynamics

Demant's first half report showcased a robust performance, notably driven by strong growth in hearing aids, which capitalized on broad market share gains resulting from recent product launches. Organic growth for the group climbed by 13%, with even higher growth in hearing aids and promising developments in hearing care and diagnostics, supported by strategic acquisitions. Growth in communications, however, lagged due to weaker demand in gaming and enterprises. The company saw an increase in EBIT by 27%, a record high, reflecting substantial operating leverage benefits in the hearing healthcare segment.

Financial Health and Earnings Guidance

In spite of exchange rate headwinds and an increased operational expenditure (OpEx), the group delivered a solid cash flow from operations and improved financial leverage. Encouraged by these outcomes, Demant adjusted their full-year outlook, elevating organic growth projections from 6-10% to 11-14% and nudging EBIT predictions from DKK 3.8-4.2 billion to DKK 4-4.4 billion. They are cautiously optimistic about gross margins in the second half, expecting improvements.

Strategic Decisions and Sustainability Efforts

Demant has focused on streamlining its business model, particularly in the communications segment, where they intend to optimize the balance between cost and sales by targeting specific markets and improving their product mix to enhance gross margins. In addition, the company has reduced its CO2e emissions, with science-based targets approved, and an increased share of renewable energy usage to 22%. They continue to push for gender diversity, particularly in top management.

Market Forecast and Competitive Edge

Looking ahead, Demant is confident about maintaining a stable growth rate of 5% since 2019, suggesting positive market dynamics in most regions, with minor exceptions. The company has witnessed dynamic shifts in its premium product mix, capitalizing on the free-choice model that resonates with educated audiologists and discerning customers. This has been especially evident in their hearing aids segment, where new products like Oticon Real have significantly contributed to revenue growth and market share gains.

Communications Segment Challenges and Cochlear Implant Divestment

The company expects ongoing difficulties within its communications segment but remains committed to long-term growth. They anticipate the market for Enterprise Solutions and gaming headsets will continue to be challenged throughout 2023, resulting in a larger EBIT loss compared to 2022. Despite these challenges, they are preparing for market recovery and anticipate an improved performance in the latter half of the year. Additionally, while the divestment of Cochlear implants is still projected to close at the end of the year, Demant will retain its bone-anchored hearing solutions business for now.

Earnings Call Transcript 2023-Q2

[Mathias Møller, Director, Head, IR]

Good afternoon, everyone. Welcome to our conference call held in connection with the publication of our Interim Report for H1 '23, which we released after the market closed yesterday. Plan is to run through a presentation. As always, digging into the results and the upgraded outlook we delivered, followed by a Q&A session. A presentation has already been uploaded to our website. This session will be around an hour or maximum of an hour, as usual. No changes to the team here, President and CEO, Søren Nielsen; CFO, René Schneider and the IR team is represented by Peter Pudselykke and myself, Mathias Møller.

Over to you, Søren.

[Søren Nielsen, President & CEO]

Yes. Thank you very much, Mathias, and welcome, everybody. I'll try to do this quick so we have time for questions. We came out with our report for the first half yesterday, and it is a very strong result we come with, and it points well for the fall as well. and it is driven by very strong growth in hearing aids, which is broad-based market share gains across channels, across geographies, fueled by our recent product launches that we have seen continue to deliver and drive share gain in the market. We have also seen strong growth in both hearing care and diagnostics, strong organic growth but also fueled by and supported by meaningful number of acquisitions over the past 12 months.

Communication on the other hand, saw a disappointing performance below our expectation that this is primarily due to a weak market, not just in gaming, but now also in enterprise where we see a growing number of business holding back on the expected investments in this type of equipment. Our CO2e emissions reduction targets, science-based targets have been approved, which we had before and for the work to deliver up to that continues. As already announced on the 22nd of June, we can now only expect to I've only had approval for, I would say, almost transferring our obligation towards CI patients to Cochlear, whereas the [indiscernible] implant business remains and stay with Demant for now. And we will later on decide the exact future for that. But for now, it stays with the group.

Key financial takeaways from the first half. Organic growth of 13% for the group, a decline to gross I'm sure we're going to get back to more details of 1.3%, which is below original expectations, but mainly related to a number of adverse exchange rate effects that I'm sure one will explain in further detail in a moment. OpEx increased 7% organically reflect, of course, continued investments in the Healthcare business, while at the same time, saving cost in communication and are in a weak market to minimize the loss.

EBIT for the group was a record high, just about DKK2 billion, an increase of 27%. Margin increased 1.4 percentage points driven by material operating leverage, of course, in the Hearing Healthcare business. Very strong cash flow from operation of DKK1.8 billion and this has improved also gearing leverage, et cetera. And based on all this and also adjusted update to our expectation for the development of the hearing aid market. We have adjusted the two main adjustments to our outlook is the organic growth rate we have increased from 6% to 10% to now 11% to 14%, and our EBIT full year EBIT from previously 3.8 to 4.2 to now 4 to 4.4.

On sustainability achievements, first half this year has been a good one. We have seen approval of our science-based targets. We have seen a reduction of our emissions and the share of renewable energy is at 22%, which means we can now measure and follow it, and I'm sure it has increased. We have also seen an increase to gender diversity, meaning more women, especially in top management but also across all management. Hearing Healthcare in a few more details, organic growth of 15%, primarily driven by a very strong performance in hearing aids, but also Hearing Care Diagnostics. Gross margin declined 1.4%, again related to you will call it higher unit cost, but it is related to exchange rate effects, again, will explain in more details.

OpEx grew 9%, reflecting that we continue to invest in this business and see, of course, now good or have seen good returns. Acquisitions was on OpEx, 5% in/and driven primarily by the expansion in Hearing Care, where we have seen significant expansion also through acquisitions. EBIT in Hearing Healthcare, €2.16 billion 28% up from the first half last year and a significant margin expansion of 10 percentage points, again, of course, reflecting strong operating leverage, not the least in hearing aids.

And the hearing aid market in first half '23 have developed positively. We have seen in Q1, 7% as already reported. And then you would say only 3% in Q2, but this is the whole trick that this is exactly the same size of the market. It all relates to the comparison figures. So if we allow ourselves to look back to '19, which we see as the last stable year, we actually have seen exactly 5% growth on a CAGR for the both quarters and for the full half year. We have seen Europe being more flattish where NHS have grown and that have outmatched the negative development in Germany and France.

North America has been solid, and that is you would say, a recovery after last year's somewhat depressed market. We continue to see growing share of managed care in U.S. in the first half of the year. Rest of the world growth is very strong. This is primarily driven by the recovery in China after a long period with lockdowns and various corona effects. Hearing Aids in details, very strong growth 20% in second quarter, and therefore, a continued strong performance. Remembering the market was, you could say, a stronger comparison was stronger. So this doesn't really reflect much of a decline, but more a continued very strong momentum, fueled by not the least Oticon Real, but also the other new products released.

It was 18% on units, 4% on ASP, mainly reflecting geography, channel mix, but also price increases implemented last July. Hearing Care positive momentum of organic growth in most major markets outside U.S. and France, U.S. flattish but France declining as the market, however, in France, we gained share. So, we have declined less than the market and other regions basically all performed very well in Europe, especially Poland and U.K. North America, Canada and of course, China and Australia, I would say, leaving corona behind.

Diagnostics, we estimate that we -- the market has grown in line with expectations. We have grown more. Part of it in Q2 is a catch-up from first quarter where we got a little bit behind schedule due to the ramp-up in our new factory, but all in all, a solid organic growth in the first half and also a nice contribution from acquisition. Communication, as spoken to earlier, 15% negative organic growth, reflecting basically the market, we think this is more or less in line with the market. Of course, now the same level of statistics as we have on the hearing aid side, but that's our big estimate.

We have seen a substantial decline to the gross margin. This is both a scale issue, but also significant promotions that have had to take place to push sales especially within gaming. OpEx decreased by 16%. This reflects the cost-saving measures that we did in the half this year and second half last year, and unfortunately, not able, of course, to fully cover up for the decline in gross margin as well as the negative growth in the sales side.

And therefore, an EBIT bigger EBIT loss bigger than last year, DKK148 million, which is, of course, not to our satisfaction, we estimate that we saw negative growth in the market in Q2. Our growth disappointing, and again, we now have both affected gaming as well as enterprise solutions; however, with the launch of our new flagship product, IMPACT 1000. And following releases, we expect we can improve the run rate during the second half of the year.

And with that, over to you, René.

[René Schneider, CFO]

Thank you, Søren. So a slight repetition of our segment reporting, but again, just highlighting the very strong Hearing Healthcare performance and operating margin of more than 20%. Of course, on the group numbers, partly offset by the negative contribution from our Communications segment. But all in all, 18% operating margin in the first half year and a strong improvement over first half year of last year.

If you go into the more detailed analysis of the different components, we have seen a gross profit increased 15% to now above DKK8 billion. Whereas if we look at the gross margin, it declined 1.3 percentage point and is below our original expectations going into the year. There are a number of effects, but in order of importance it's important to understand what exchange rate means in the year-over-year comparison.

And in ballpark numbers, looking at first half year, last year, we had a tailwind from FX of a little more than 0.5 percentage point, meaning that the underlying gross margin in first half year of '22 was actually very close to at 74%. And actually, this year, first half year, we have had a headwind of also just above half a percentage point on the margin, meaning that the underlying gross margin in the first half year has actually been 74%.

So that's one important element. And that is part of what gives us comfort in the gross margin going into second half year. Another important effect that we have seen in the first half year is basically the effect of a FIFO accounting, meaning that the raw materials purchased the work in progress produced in second half year of last year was done at a very high U.S. dollar.

But since sales were below our expectations last year, in effect, we have been expensing and selling those products in the first half year of this year, which means that the high dollar effect actually hit our P&L in the first half year of this year. Looking at sort of the gross margin in our group towards the end of first half year, we have seen a significant improvement also as a result of us getting basically through the expensive inventory stemming from last year.

And the last effect to highlight is the effect that Søren already spoke of, which was the high level of promotional activities in gaming. So all in all, the run rate going into second half year is the around 74% and also with some opportunity to improve from there. And therefore, we have a high degree of confidence in the fact that we will see improvement in second half year compared to first half year on this particular financial margin.

OpEx, we grew at 7% organically, driven by Hearing Health care, so significantly below our organic sales growth, reflecting strong operational leverage. Also acquisitions contributed by 5%. And obviously, we have seen savings in communications, as already alluded to. EBIT was 2 -- just above DKK2 billion, a growth of 27%, driven by our Hearing Healthcare business. exchange rate had a negative effect of slightly more than DKK50 million, part of what was in the gross margin, as I explained before.

And in the period, we have seen a net positive value adjustment around of actually exactly DKK29 million. Cash flow was also very strong in the first half year, Cash flow from operations just shy of DKK1.9 billion, driven by strong EBIT and strong working capital management and particularly driven by lowering of inventories. CapEx in line with our medium- to long-term expectations of 4% and investments in acquisitions amounted to DKK330 million, a little bit shy of our expectations, but we still feel that for the full year, we will be above the normal level. So it's mostly related to timing of acquisitions.

The balance sheet year-over-year since the beginning of the year has been flat, a small effect from FX downwards of 1%, but offset by predominantly goodwill related to acquisitions and a write-down of CI related assets. End of the period, our net interest-bearing debt was DKK12.2 billion, and we are now slightly below the upper level of our leverage guidance range of 2 to 2.5 meaning that we are now back in the range where a share buyback is an opportunity. That brings us to the outlook.

[Søren Nielsen, President & CEO]

Thank you very much, René. Thank you for that. And a number of things have been upgraded and adjusted. And the first and important one to understand is that our outlook for the hearing aid market we upgrade. And we do that because we see a new level of stability. We have seen a very, very stable run rate in most markets France and a few other excluded, but it's always like that.

And back to the 5% CAGR, back to '19, we expect basically the same for second half, which implies a small growth from first half into second half. And if you do that mathematically, you will simply come to growth rates above the 4% to 6% for the full year. So we now believe we'll be outside that. And of course, that implies the second half that it will be even more above but you I'm sure can quickly do the math yourself, and you will see it. We still expect ASP to decline with 1% to 2%. That's basically mix effects, some channels growing more than others, natural competition.

And also, we still have China coming back after a week period. That's an example of a geography with lower ASP and strong unit growth, so that's unchanged. We now also expect a weak momentum in the market for Enterprise Solutions and gaming headsets to continue throughout '23. We previously had a somewhat positive idea towards the end of the year, but we have no line of sight to that.

And therefore, remains negative on the development for the rest of the year. And therefore, also now believe in negative organic growth for communication for the full year, hopefully, an improvement or we expect an improvement from first half into second half of the run rate of sales. But it will despite of the efforts to do cost savings lead to an EBIT loss that is bigger than the level of '22.

We will, of course, continue to look for opportunities to further reduce cost and be careful on how we spend the money. But on the other hand, we also need to stay in the game in the belief that long term, the market will, of course, come back at some stage. And then also the divestment of Cochlear implant. We assume it's still to close at the end of the year. And again, [indiscernible] will remain for now.

Organic growth upgrade from 10 to -- 6 to 10 to now 11 to 14, and EBIT up as well, as I mentioned to now 4 to 4.4. Also, we have to say that the net financials, despite of us actually decreasing our debt, will increase, more likely, to be DKK700 million instead of assumed DKK600 million. The tax level, we expect to go down a little bit compared to previous expectations. And then we narrow a bit the loss related to the discontinued business. It actually reflects, of course, more clarity on timing and cost, but also the fact that the operating business underneath is performing slightly better than anticipated.

The big part of this loss is the adjustment to various assets and goodwill on the balance sheet. And with that, let's open for Q&A.

[Operator]

[Operator Instructions] Our first question will come from Hassan Al-Wakeel with Barclays. Thank you for taking my question.

[Hassan Al-Wakeel, Barclays]

I have two, please. Firstly, could you breakdown your commentary of a better than 4% to 6% market growth rate after 2023 by region, particularly given you mentioned that H1 was 5% and Europe was flat and decelerated Q1 to Q2? I understand some of the comments you made around comps, but what is the assumption for the second half? And then secondly, could you walk us through your confidence in drivers around H2 implied margins, given the midpoint implies over 350 basis points of margin expansion year-over-year in the second half and around 150 basis points sequentially. Are there any one-offs that we should be thinking of?

[Søren Nielsen, President & CEO]

Let me try to elaborate on the market, and it's going to be a little bit around. But again, our main assumption is when you put it all together, we will see a CAGR growth since '19 of 5%. And you can basically do the same for all markets, except France, which has had significant ups and downs in the period and maybe a little bit China and a few other markets.

But the majority of markets would fundamentally land around their natural growth rate, you could see. And that implies that we will see just from the bear effect of continuing the absolute market size we have seen in first half and a little bit of growth just by the nature of growing moving forward that you will find growth rates above the 4% to 6% in basically all regions.

But stronger in Asia due to China, a little stronger in the U.S. since the uncertainty in second half coming from inflation, et cetera, was stronger in the U.S. than it was in Europe. Europe was kind of lacking that effect compared to North America. So that's basically it. And again, it's quite simple to model it out. And Rene, if you could...

[René Schneider, CFO]

Yes. So on the implied margin for second half year. So I already pointed to our expectations to also higher gross margin, which is, of course, one driver that has, you can say, pulled down one extraordinary. So we have a firm belief that, that will revert in second half year. And then as also in our guidance, you have an implied a significant organic growth.

And as we see in first half year, when we are growing the business, we also have operating leverage and on particularly also on the OpEx side, and that will also continue into and potentially further improve into second half year. And then as a business, if you look into previous years, we have a level of just general seasonality and higher profitability across businesses in the second half year. So all of that combined gives us significant confidence in margin expansion.

[Hassan Al-Wakeel, Barclays]

That's helpful. Sorry, and if I could just follow up on EMEA and I guess what are you seeing in exiting last quarter, July and this quarter in terms of any potential recovery? And how are you thinking about replacement versus new customers in Europe?

[Søren Nielsen, President & CEO]

Yes. I don't have that level of granularity. Here, my message is stability. And Europe have had and will have a less than the five, six percentage growth that have had it. Many countries in Europe are more likely growing 2%, 3%. So I think you will find that that's the the CAGR is maybe a little bit lower in Europe than it is in the rest of the world.

But we also, in Europe, see stability again outside France. So not a lot of going up and down, and that's the main communication here that putting it all together, including Europe, you will see a slight growth from first half into second half, and that in itself implies a higher than the 4% to 6% growth rate. We have not broken it down on each market.

And you will see, as always ups and downs and swings in every form here, not one there. So that's not -- we're not down to individual markets. This is putting it all together then we are within the normal deviation market-for-market and all together a very, very high level of stability, basically first time for four years where we believe that there's at least not side to any significant uncertainty that should change this. And that's the reason for the upgrade.

[Operator]

Thank you. We'll take our next question from Veronika Dubajova with Citi. Please go ahead.

[Veronika Dubajova, Citi]

I will keep it to two as well. I just wanted to get a little bit of flavor for the competitive environment that you're seeing, Søren, and relative momentum versus peers. I noticed in the [indiscernible] the last couple of we've seen a little bit of a slippage in your market share. Just curious if that mirrors what you're seeing in the broader market. And obviously, we get your Q1 and Q2 growth rates. But if you could maybe give us a flavor for how you think you're competitively doing exiting the half year and moving into the back half, that would be really helpful. That's my first question. And then my second question is just M&A...

[Søren Nielsen, President & CEO]

Veronika, sorry, the line is not very good, but I can see Peter got the question. So now I'll ask him to repeat it instead of trying you to repeat it.

[Peter Pudselykke]

I guess, Veronika, competitive environment now exiting kind of H1 on a competitive side, is that greatly understood?

[Søren Nielsen, President & CEO]

We assume so. Second question?

[Veronika Dubajova, Citi]

Yes. And my second question was just around your M&A appetite I know when you came into this year, you were hoping to be more acquisitive you've gone a bit more than usual, but I'm taking your sort of buy that commentary to mean that maybe it's not going to be as much as you had thought. What's changed in the market? Is it that you have less appetite is that there are fewer assets? Or is it that the process is more competitive?

[Søren Nielsen, President & CEO]

I get the question. First of all, competitive environment. Again, I think it's stability we know and have now confidence and evidence for the strength of our own product portfolio. I always say it takes three months, four months before you're really sure whether it biased. It does bias. We continue to see Oticon Real and the other products we have launched open doors to new customers.

And so we still see share gain, not across all markets, all channels, but if nothing else, maintaining strong momentum, but also in a number of channels, obviously still having effects of a full period. VA is an example. There's only two months in the first half. There will be six months in second half, but also, again, among the independent dispensers that is a long way around, and we continue to see Oticon Real and the other products, deliver new opportunities and growing sales.

On the M&A, there's no change to the full year guidance. This is simply timing. We had expected that a few more things would land in the first half and second half. It is a pipeline, things sometimes take a little longer -- it can be final discussions or authorities that have an opinion, seller get second thought, whatever. So there's no change. We have no more or less appetite. We have not changed our view on where we should acquire. We have not seen changes to pricing anything. So, also there are pure, pure timing between the two half years.

So the commentary on the share buyback, just to take that is just that the residual after acquisitions, after investing in the business after servicing our debt, there is a variable on all the three. And therefore, we can see we are within range. And when we are within range, we can buyback share if we want to, but we have not full transparency to if it will happen and it when. And therefore, we are only now flagging that it could happen in second half because we have theoretically -- they have way it is a relevant discussion.

[Veronika Dubajova, Citi]

Very clear. And Søren, can I just ask any tailwinds you saw in the second quarter from the manufacturing and supply chain issues that one of your large competitors having? Was that a notable driver in Q2?

[Søren Nielsen, President & CEO]

Not that I'm aware of. Again, this is broad-based and across channels and so on, so I attributed to our own -- the strength of our own product portfolio.

[Operator]

We'll take our next question from Martin Parkhøi with SEB.

[Martin Parkhøi, SEB]

Martin Parkhøi from SEB. A couple of questions.

[Søren Nielsen, President & CEO]

You're impossible to hear. If there's a closer to a microphone or something.

[Martin Parkhøi, SEB]

But it cannot be closer to your mouth unless it's out. Great. Just maybe, Søren, I know it's still one year down the road, but we're getting closer to the update the five-year update with also expected price negotiations. Now we see that the cost comprises again, on the branded segment going down again just recently -- and that has happened a lot of times since the VA was negotiated the last time. Should we expect to see a significant reset of the pricing in VA when you will update your contracts next year? Then the second question on communications. You are, of course, now guiding even larger loss in '23 than in '22. If I look at the last two years, the loss has actually also been larger in the second half than in the first half. How should we look at the communications loss in the second half compared with the DKK148 million, you delivered in the first half? And then just maybe lastly, to Rene. Just on your cash flow generation in the second half, of course, some things you cannot say right now compared to the first half. But how should we look at the cash flow generation with respect to working capital changes, can you elaborate a little bit on that?

[Søren Nielsen, President & CEO]

Yes, let me take -- I will not comment on pricing. It's -- you will see when it's done how things go. But remember that Costco also, to some extent, went the other way when KS was canceled, you saw an uplift to the consumer prices. So, I wouldn't see it as dramatic as you might see it. And then regarding losses, growing sales and cost down, that's the recipe, and we expect a less, but up to the same-ish kind of, I think, is a fair estimate for second half, but don't take it more precise than that. That was not a guidance.

[René Schneider, CFO]

And kind of a similar answer to cash flow. But one of the most difficult items to actually forecast, but we feel confident that, of course, it's positive and it's strong and whether it's in line with first half year or above or below, we cannot be specific on, but we are we are continuously month-by-month generating a strong positive cash flow. So I assume the same for second half year, but a specific number, I cannot give you.

[Martin Parkhøi, SEB]

So if I could just follow up on the communications because then we're looking at a loss of more than DKK250 million this year, which is 1/4 of the sales you probably generate. So even with 10% growth every year, it will take a lot of years before you will be positive again. You are always quite comfortable when the market picks up, it will also be good for us. But do you actually think that you will be the first in line to capture market growth once it happened, considering the significant scale down you have done in your cost base?

[Søren Nielsen, President & CEO]

Yes, I think you have to remember we are very unevenly distributed company. We're not a global company acting in all markets. We do actually have a number of markets where we have a good decent share and will also get our share when the market picks up, I'm sure. And one of the cost reductions we have done is to better fit. We were scaling the business for a lot of growth and expansion in new markets.

So one of the things we have done is to narrow the number of markets we actually address right now and make sure there's a better local alignment between cost and sales. So that is one example. Secondly, we also do expect that we would have somewhat changed product mix, more of the new staff and wireless products on enterprise instead of selling out high inventory of gaming headsets at low prices, we'll see an improvement to the margin -- gross margin, that's also part of the solution. Otherwise, yes, it would take a very long time.

[Operator]

We'll take our next question from Chris Gretler with Credit Suisse. Please go ahead.

[Chris Gretler, Credit Suisse]

I have two questions. Maybe first, not just on operating expense growth in Hearing Healthcare, I think that was somewhere around 9% organic. Is there something special in there? Or can you maybe kind of clarify why we've seen such strong growth, which is, obviously, way ahead of inflation, et cetera. And what were the investments specifically maybe. That will be my first question.

[Søren Nielsen, President & CEO]

Yes. Please continue, Chris.

[Chris Gretler, Credit Suisse]

The second question would just come back to Communication EPOS. I think in your slides and you have your report, you mentioned that you might review that business to align it to the current activity levels. Is there something else you can do in order to just from cutting cost here? I mean, structurally, that would improve margins? And in particular, also where do you see actually a reasonable gross margin for that business since we had this substantial drop in this first half?

[Søren Nielsen, President & CEO]

Thank you, Chris. The OpEx organic growth, there is an element, I would say, almost of normalization also there. As we came through '22, we kind of pulled the brakes, especially on the hiring for open positions, which hits, among others, R&D quite significantly. So the normalization and getting all the precision filled was part of it, but also further investments in R&D that is the main organic growth.

And that is, of course, because we, once again, think we have seen and proven that it is a key driver for share gain to bring out the innovation and products that are significantly above your competitors. So that's the main area. On Communication, the alignment I talked about. So you're sure we were in much more growth mode and investing in new markets and building markets where we had very low share building basically a new brand and so on.

Some of these things, we reduce sponsorship of gaming teams and what have you, you simply have to have a better alignment between the market size and your sales and marketing cost. And that's both a geography, but there is also promotional elements where we have just seen too lower return in the market. So it's that kind of review we will do ongoingly, as an example.

[Chris Gretler, Credit Suisse]

And maybe if you allow I have one follow-up just on substantial share gains in hearing aids. Is there any way you can kind of discuss what kind of accounts that you actually kind of being so successful? Is there kind of a common factor or something because it's really kind of very impressive, I think, in units in particular.

[Søren Nielsen, President & CEO]

And it is, as I said before, really broad-based. There is, of course, you could say, part of the unit element that comes from markets that have seen a high growth rate and returning NHS have been above the normal. China have been above the normal. But of course, the strongest effect is in markets where the share of people that are willing to go for the best, and I don't know I've spoken to this many times, free choice leads to better product mix when there's something good around. The product mix is not a fixed dimension. It's very dynamic. So independent dispensers, well-trained, well-educated audiologists they fundamentally want to do a good job.

And they are just good in explaining the benefits that people try one or two models. And if you do that and feel and see the benefits, you go for the best. It will be exactly the same as basically any other healthcare cost. Whereas, of course, if you're in a more fixed system where somebody controls what you get, then you see less of that effect. And it is the very significant uptake to our new and latest products that are primarily sold in the premium end of the market. That is where we have seen both the volume uptake and of course, also a nice ASP so U.S. market is a key market but also across Europe and yes, markets with, I would say, free choice.

[Operator]

Thank you. We take our next question from [indiscernible] with Bernstein. Please go ahead.

[Unidentified Analyst]

So just on the retail side, could you give a bit more color on your performance in the U.S. market -- and so to an extent to the exit of managed care contracts, is that still impacting growth this quarter? And then I guess, more broadly, do you feel the restructuring you've done has positioned you for growth? Or is there more work needed there?

[Søren Nielsen, President & CEO]

Thank you. I would say if you look at the market and say, manage care going then our U.S. business is organically flattish, but that's also our best estimate for the market. So it has also seen some positive effects from better product mix, also benefiting from a new stronger premium introduction, it also has seen a headwind from closed stores where the traffic was not high enough.

And of course, a growing share of managed care continue to make the marketing effort more and more intense. That's just the nature of it. Given those circumstances, given the reduced network, we have seen a very good performance in U.S. It's in line with what we expect and had planned for, and we have seen growing profitability and that was the main driver between for the exercise.

It was not to generate growth, but it was to grow profitability. So less managed care replaced not maybe one-to-one by private pay sales reduced network where we could not fill the schedule without too much managed care, et cetera, black spots where we couldn't hire staff, et cetera, so there's a growing profitability in the business despite of a flattish organic growth.

[Operator]

Thank you. We'll take our next question from David Adlington with JPMorgan. Please go ahead.

[David Adlington, JPMorgan]

Maybe first on Communications. Just wondering how you are feeling about that purchase and the carrying value of the asset? And then just on the gross margins there, just any sort of thoughts around whether you've peaked in terms of promotional activities and how we should be thinking about the evolution of the gross margins through the second half possibly into next year? And then just on the Cochlear business, do you want add any to or further color and update on the process happening on the Cochlear side?

[Søren Nielsen, President & CEO]

Again, we are still firm believers in the health and strength of this market in the long run. There will be more online gamers. There will be more people working from home. We will all work more virtual. So the long-term growth is going to be there. I think we have fundamentally seen a reset before COVID, there was one extrapolation of the world and everybody got maybe overexcited during COVID and post-COVID for working from home and so on. And the estimate for the future growth was kind of endless.

Now we have seen, you would say, a reset to another level. And from some point, there, we will start to see growth again. I'm sure. Therefore, it still makes sense for us to be there. But we need to align the business to the size of the market. And that's key. We do have scaling issues, of course, and that's part of the gross margin in addition to the promotions. The promotions will tailor off when -- yes, we are out of it is related to some co-branded products we can only sell for a certain period.

So, we better sell them for what we can get. And then the product mix and the business mix, which, again, a newer product range in enterprise will also work for a better gross margin. Long term, we still believe the natural place for that is between 40 and 50. But again, we cannot put an exact dot as the scaling effects come pretty hard into play when we had this level of sales as we are right now. On the CI, nothing to add. We are working on the details and hopefully, as planned -- or we expect as planned to finalize the deal and close at the end of this year.

[Operator]

Thank you. We'll take our next question from Mattias Häggblom with Handelsbanken. Please go ahead.

[Mattias Häggblom, Handelsbanken]

Two questions, please. Firstly, in June, one of your key competitors decided to move into the OTC market with a new product introduction from Senso. What do you see in this early creation of the OTC market that keeps you outside? Or are you in a wait-and-see mode to evaluate the business or the market creation or as a permanent decision we made not to launch in the OTC channel? And then secondly, can you remind us around the key currencies leading to the gross margin headwind in first half '23 compared to a tailwind in the first half '22 for hearing as it seems have surprised the market somewhat?

[Søren Nielsen, President & CEO]

I'll take the first, and Rene will comment on the second. There's no change to our OTC policy. We still see this as very, very early, and we don't see that there is a very strong first-mover advantage. Secondly, I must say so far from a pure financial and statistical point of view, the sales is not overwhelming.

And I think I'll still be somewhat conservative in the changes among the consumer, the reason for a slightly lower penetration in the U.S. against, for instance, Denmark is not whether or not OTC is available. That's purely that you have a free-to-client system here in many European countries the chance that either online sales, which we -- I think we have seen several evidence of or a sales taking place in a store with no professionals, no guidance at all is a long change if ever.

[René Schneider, CFO]

Yes. So to elaborate a little bit more on the margin -- gross margin part, if I should point to one main driver, it is the development in the U.S. dollar over the last 1.5 year. And it translates into two different effects. One is the the translation and total hedging effects that we realize on an ongoing basis. That's one effect.

And the other effect is that we continuously when we source raw material for production, we predominantly buy in dollars. And it was an effect second half year of last year that we bought a lot of inventory, let's say, an unusual high level of inventory at a very high U.S. dollar rate, combined with the fact last year that we sold less than we had expected, meaning that we, end of year, sit with a very high-value inventory that we are essentially selling in the first half year of this year, where on the sales side, the U.S. dollar is lower.

So it is to point to one thing, the driver of these effects is the U.S. dollar. And that's where I say, if we stay at the U.S. dollar level that we have today or at least see say, less material swings month-over-month as we saw last year, then we are in a situation where the gross margin is back to the levels that we know of historically and also with an opportunity to improve from here.

[Operator]

Thank you. We'll take our next question from Oliver Metzger with BHF.

[Oliver Metzger, BHF]

Yes. The first one is on the market. So regarding the repurchase cycle, the reason for the slowdown last year. So did you observe a reversion to previous levels? Or just that after the lengthening last year, this period has remained more stable from now? And second, can you quantify pent-up demand in diagnostics. So is it fair to assume that if you look for H1 organic growth, that this is more of a proxy of the underlying development because you had this quarterly volatility related to the Poland issue?

[Søren Nielsen, President & CEO]

Let me take [indiscernible] first. It's always difficult to separate the hot and cold water when you have mixed it, whether there's still some that postpone a bit and some that come back from the fall, you cannot tell we would people are not attacked like that. we can just conclude that the absolute size of the market is exactly where you would have expected it to be had you predicted it back.

And that, of course, means well, maybe there is a little bit of pent-up demand and maybe it's just a wave that still move ahead of us. We will never really know. I think from COVID, we had some much bigger deviations and you can discuss whether we have ever seen them back or whether we had seen as much postponement as we have seen pent-up demand coming in. And I guess that theoretical discussion will never end until 20 years this past -- so we no longer spend a lot of speculation into pent-up demand.

We just say the market size now seems incredibly stable. Sales per day run rate split between new users and existing users, length of repurchase periods and so on, things seems to finally after a long period with a lot of fluctuations to be back to the normal stability, doesn't mean that you don't have fluctuations in individual markets. But when you put it all together, the predictability and the stability that we have known for many years of the hearing aid market seems to have re-found its balance.

And maybe Rene, you could comment on diagnostic?

[René Schneider, CFO]

Yes. Well, on the Diagnostics side, we haven't talked about pent-up demand as a theme because contrary to the hearing aid side the Diagnostics business actually went through the COVID period relatively unimpacted or unaffected and has been performing fairly stable since then. So that's not really a topic and there's no pent-up demand out there, you can say.

[Oliver Metzger, BHF]

Sorry, just to clarify, the pent-up demand was related in Q1. Growth was slower as you had the inventory stuff.

[René Schneider, CFO]

Thank you for clarifying. So surely, we went into the second quarter with a fairly high order book and backlog. So of course, that has fueled Q2 to some extent.

[Oliver Metzger, BHF]

Okay. Great. Regarding the market, just one...

[Søren Nielsen, President & CEO]

In totality and see that as a reflection of the underlying business.

[Oliver Metzger, BHF]

Okay. Okay. Great. A quick follow-up on the market and also on China because the dynamics in China seems to be different, there was a huge pent-up demand after stopping the zero COVID covered policy. And do you see right now after the first wave of pent-up demand, that underlying growth is still as healthy as you would expect or as it was before the whole pandemic?

[Søren Nielsen, President & CEO]

Yes. Thank you for the question. The reason why the immediate pent-up demand was so strong was when you totally locked down, then there are people simply waiting to get help. That's exactly the same we have seen all around the world. It's more when there was COVID and you were under restrictions to who came out and no doubt.

So that part was primarily a Q1 effect. What we see now is not a China, you wouldn't apply a 5% CAGR since '19, you would have had to take a bigger number. And yes, it seems like the further development of the Chinese market.

And remember, it's not a mature market. It's one where you need to open stores, train our geologists and so on before you tap into that basically enormous untapped potential that is there -- and that process for sure, have been delayed. And therefore, the market today is smaller than you would have stipulated back in '19.

And that's because it's a growing market, driven by a growing structure. And that's, of course, different than, let's say, Europe or U.S., where that part is very steady and only growing in line with the underlying demographics because the penetration is unchanged. When the penetration grow, number of stores grow, then there is a setback. You cannot just catch up and open hundreds of stores that should not be an open in '20 and '21.

[Operator]

Thank you. We'll take our next question from Morgan Davies with Morgan Stanley.

[Robert Davies, Morgan Stanley]

It's Robert from Morgan Stanley. Just a couple of questions, most of them have been covered actually. One was just around the boost you think within the numbers you had in Hearing Healthcare over the last quarter, just from Oticon Real specifically, if you can kind of separate out that kind of benefit, I guess, as part of the overall growth print? And then secondly, just coming back Communications commentary, I know you've, obviously, given some guidance of 23%. I'd be interested to know what your view is in terms of a time line for breakeven. If there's any sort of change in thoughts there in terms of the medium-term profitability time line?

[Søren Nielsen, President & CEO]

The boost from Oticon Real and these products are very big because the ASP is high and the volume is strong. a very big number of instruments are sold in this category at very attractive pricing. And therefore, the absolute element is very big. That's also why you see share gain and growth like we have seen.

Of course, we are broad-based. So we also grow not all the extra units are Oticon Reals, but from a revenue point of view is quite meaningful. On communication, we do guide on that. But of course, next year have to be better than this year. That's for sure. And we have to find a way to a much better result. It is very painful to see losses at this level. I cannot tell exactly when it happens, but it's -- I can assure you high on the agenda.

[Operator]

Thank you. We'll take our next question from Martin Brenoe with Nordea.

[Martin Brenoe, Nordea]

Maybe just one clarifying question on the diagnostics. Could you provide some color on the large tender that you've won in Q2 just in terms of what the contribution is and whether you see the full contribution now or whether it's a gradual one. And maybe also how long that contract will run? Secondly, you saw accelerated growth in China in the Hearing Aid business and the Hearing Care business. Do you think that the market is just an upward trajectory from here? Or do you see any potential cracked clouds on the sky there?

[Søren Nielsen, President & CEO]

On the Diagnostics, it's just a mentioning of one example like we have in others. So it is part of it. I can say is, and I think it's a very good illustrative example. It is within balance. And it is a market where we, over the past years have invested a lot in training and education, which is exactly what happens.

And then eventually a healthcare system, whether it's private or governmental decide, okay, we step into after various trials offering this treatment and diagnostic broader based. And then you need a certain level of equipment.

And then, yes, in this case, there was a tender and part of it has been delivered and some will still come, but it's just an example of a meaningful, of course, sized tender, but they are there all the time, it is, to a large extent, the tender-driven business. So don't read too much into that. And could you take the last one more time? Sorry, I just lost my notes were not good enough.

[Martin Brenoe, Nordea]

Yes. So it was about China just that you saw accelerated growth...

[Søren Nielsen, President & CEO]

Yes. Well, just from the pure demographics and the low penetration, China will grow above the global level of the 4% to 6%. And yes, we will think it could very well be double digit. But of course, like any other market, you will see fluctuations from year-to-year. And you should be very careful in a market where we don't have statistics and where sales is not a pipeline. China is still working like this that when you come in, in the morning, there is people in the waiting room, and you don't know where they came from or how many are there today?

And if there's not enough, you go out and try and get some more and call out. It is not at all matured to the level we are used to here in Europe, where we know our booking system and know how many when there's overbooking and underbooking and so on, we are not at all at that level yet. So therefore, we are very cautious in short-term estimation of market growth and guiding for the next three months. China, big picture in the next five years will grow significantly more than the rest of the world.

[Operator]

Thank you. We'll take our next question from Niels Granholm-Leth with Carnegie.

[Niels Granholm-Leth, Carnegie]

Just a question and clarification about your longer-term guidance, which you provided at your Capital Markets Day last year, you were mentioning that you want to improve your margin level. So would that include margin expansion even in 2024, you think? And then you also aim for 6% to 8% annual organic growth. Should we see this as an average? Or would you say that 6% is kind of a floor guidance?

[Søren Nielsen, President & CEO]

I think you also almost know the answer yourself. Yes, the 6% to 8% is an average, and we have to ambitiously being there. Could that be one year below 6%? Of course, it can happen. Would it be a great year? No. So we aim for being in that interval and preferably in the higher end than the low end. And margin level, it is the scalability. And I think we have argued numerous times for the value of the scalability.

And with the level of growth here, we see it, had we had not the exchange rate effect on the gross margin, you would have seen also strong leverage on the cost of goods sold from an 18% uplift in volume, of course, taking a little bit down by more rechargeable, which is still a conversion going on. But you would have seen very, very clear evidence of scalability. I also mentioned the focus in U.S. on retail debt the transformation or the changes we do are meant to grow margin instead of just growing top line.

So it is with that focus. And I will not guide on '24. You know that's too early. But yes, the patient is the same to get the scalability out of all the businesses and show that they can grow margin. We know hearing aids is the strongest when the growth rates get high, it comes right away. It's more difficult in Hearing Care, the store because so much of the cost happens in the store, but that's more of a customer business mix in the store.

And then in between, you have diagnostic because it has growing also distribution element, and therefore, dampens the scalability a little bit. But over the past three or four, five years where we have seen very strong growth rate. We have also there seen strong scalability. And then obviously, in communication, we both plan to and have to see over the next few years, a significant improvement to the margin, obviously.

[Operator]

At this time, we have no further questions in queue. I'll turn it back to management for any additional or closing remarks.

[Mathias Møller, Director, Head, IR]

Thank you, operator, and thanks for taking care of the Q&A session here. This is it for today. Thanks for joining us, all of you, and let us know if you have any follow-up questions. Look forward to seeing you on the road soon.

Have a good day.

[Operator]

This does conclude today's call. We thank you for your participation. You may disconnect at any time.