Fair Value Estimate: 833p ¦ Uncertainty Rating: Medium ¦ Economic Moat: Narrow
Thesis (Last updated 14/06/10)
Smith & Nephew faces tough competitors in its chosen fields, but we think its devices offer compelling value propositions.
The firm operates in three medical device niches--orthopaedic implants, arthroscopy tools, and advanced wound management. In orthopaedic implants, our favourite business of the three, Smith & Nephew remains in a middle tier of competitors, substantially trailing Zimmer, Johnson & Johnson, and Stryker in terms of market share. However, we think Smith & Nephew's unique strategy of pursuing relatively young, active patients should serve it well, producing volume growth and perhaps protecting prices if the reimbursement landscape changes. With increased scrutiny on healthcare expenditures, we think more burden will be placed on device makers to prove the worth of new products, potentially making future mix benefits harder to come by in this industry. We think Smith & Nephew has proved its innovation chops in recent years by introducing revolutionary products, such as the Birmingham hip resurfacing and Journey Deuce knee products, that help keep younger patients physically active for longer. If it can keep up that level of ingenuity, Smith & Nephew may be able extend positive mix benefit trends above and beyond volume growth in this niche for the long run.
Smith & Nephew augments its orthopaedic implant business with a highly successful minimally invasive tool business. In particular, Smith & Nephew claims the number-one market position in arthroscopy tools, which helps endear it to doctors in a fast-growing medical speciality, sports medicine. By gaining access to doctors who treat patients in the early stages of joint deterioration, Smith & Nephew hopes more patients will remain in the care of doctors who utilise its products, which could feed into the orthopaedic implant business. Even if that doesn't happen, we think Smith & Nephew will continue to benefit from the substantial growth and profitability that this business provides on its own.
The firm is taking aim at Kinetic Concepts' virtual monopoly in the negative pressure wound therapy market, too. With its gauze-based offering already pressuring Kinetic's VAC results, we think Smith & Nephew's foam-based offering, launched in early 2009, could inflict even more damage on Kinetic's $1.4 billion VAC business. We think this product set will serve as a big, profitable growth driver for Smith & Nephew in the future, especially after KCI's key patents start expiring in 2012.
Valuation
We're raising our fair value estimate to 833p per share from 746p because of the strengthening US dollar. We use an exchange rate of £0.6897 per $1 as of June 10, 2010, for all valuation scenarios in this report. Our other major assumptions have not materially changed. After a 1% contraction in 2009 because of foreign currency losses and the economic downturn, we expect compound annual sales growth to rebound to about 9% through 2014. This assumption is driven by 8% annualised orthopaedic segment growth, 10% annualised endoscopy segment growth, and 10% annualised advanced wound-management segment growth. Also, though acquisition-related costs and other inefficiencies have kept operating margins below 20% in recent years, we project operating margins will rise to about 23% by 2014. The firm has embarked on a cost-control programme that has already improved profitability, and we expect more long-term gains from this programme, especially as Smith & Nephew expands in the more profitable negative pressure wound therapy business. We expect earnings per share to grow about 15% compounded annually through 2014. We use a 10.5% cost of equity to discount our assumptions.
Risk
Smith & Nephew operates in highly regulated industries, and government mandates could damage the profitability of its chosen niches. The biggest near-term threat to Smith & Nephew's operations remains US health-care reform. Pricing pressure and mandated fees could pressure medical device makers' profits in the long run. Given Smith & Nephew's large debt position, significant cash-flow impairment could threaten its ability to repay loans under existing terms, too.
Management & Stewardship
After a decade of Christopher O'Donnell's reign, Smith & Nephew promoted David Illingworth to CEO in mid-2007 after his stints as COO and the orthopaedic business leader. We think the firm remains in capable hands and would classify the stewardship at Smith & Nephew as fair. We praise the level of disclosure provided on operations, and we appreciate the separate board chairman and CEO positions. John Buchanan, former CFO of another major UK-based firm, BP, serves as chairman. We think several areas could improve, though. We dislike the staggered board elections and requirement of a supermajority to approve special resolutions; that structure could limit shareholder influence on important company decisions. We also don't think insiders are naturally aligned with shareholders, as their stakes in Smith & Nephew are relatively paltry. This situation could increase the likelihood that insiders siphon away profits for their own compensation rather than for the benefit of shareholders. We already think that is happening somewhat now with executive and board compensation, though not at a terribly egregious level.
Overview
Growth: Although the recession and foreign currency changes have hurt growth recently, we expect Smith & Nephew to return to high-single-digit sales growth annually during the next five years.
Profitability: Profit and free cash-flow margins have trailed those of major rivals, primarily because of operating inefficiencies and restructuring charges. The firm has been improving profitability recently, though, with new product growth and a cost-cutting plan.
Financial Health: At the end of March, Smith & Nephew held only $268 million in cash and $1 billion in debt, most of which is due in 2012. Although projected cash flows more than offset this debt balance, this net debt position adds risk to the firm.
Profile: Smith & Nephew is a UK-based company with more than 150 years of operations. Orthopaedic devices accounted for 57% of 2009 sales; major orthopaedic offerings include knee and hip implants and tools to set bone fractures. The balance of sales comes almost equally from two other units. Smith & Nephew's endoscopy unit offers tools to help physicians perform minimally invasive joint surgeries. The firm's advanced wound-management business offers dressings and other devices.
Strategy: Smith & Nephew aims to build sticky physician relationships by tailoring devices to improve surgical procedures and offering extensive training with its tools. Its primary growth strategy revolves around improving procedure outcomes with each new device iteration and then boosting prices and unit volume. The firm also relies on acquisitions to broaden its product set.
Bulls Say
1. Demographic trends, such as aging and obesity, favour substantial volume growth in Smith & Nephew's biggest segment, orthopaedic implants, for the next couple of decades.
2. Smith & Nephew's focus on younger, more active orthopaedic patients could help it extend mix benefits if it can introduce new products that greatly improve patient outcomes.
3. As an established wound-management tool provider, Smith & Nephew looks well positioned to benefit from increased competition in the negative pressure wound therapy market.
Bears Say
1. Although the firm did receive a monetary settlement that lessened the blow of lost expected sales from Plus after uncovering poor selling practices, we question management's due diligence and would be concerned about future acquisitions adding value.
2. Restructuring charges and inflated selling, general, and administrative costs plague Smith & Nephew's past operating results. These operating inefficiencies suggest an undisciplined investment approach, which may not change overnight.
3. Kinetic and Smith & Nephew remain embroiled in a legal dispute regarding Smith & Nephew's entry into the negative pressure wound therapy market; injunctions, ongoing licensing fees, and other legal expenses could continue to hurt Smith & Nephew.
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