Like most of its peers, Smith & Nephew saw demand weaken for its key orthopaedic products in the second quarter. However, this weakness was not enough to move the needle on our 833p fair value estimate.
Sales grew only 4% year over year, as solid performances from the firm's endoscopy and advanced wound management segments were not enough to offset weakness in its core orthopaedic reconstruction business, where the firm only grew 1% on an underlying basis. The orthopaedic industry appears to have weakened considerably in the second quarter after experiencing substantial rebounds in the fourth quarter of 2009 and the first quarter of 2010. We contend that ongoing economic and employment concerns are causing some procedure delays, especially by the relatively young, active patients Smith & Nephew targets. Also, it appears that pricing pressure remains a key negative trend for the industry, which some firms (like Smith & Nephew) are struggling to offset with new product mix benefits. In endoscopy and advanced wound management, Smith & Nephew's underlying results also decelerated sequentially, but on a year-over-year basis, endoscopy still grew 9% and advanced wound management grew 5%. However, both of these segments appeared to get a bit of help from weak comparables when hospital capital spending and inventory levels were extremely low. Overall though, until economic and employment trends rebound substantially, we may continue to see such weakness from Smith & Nephew's orthopaedic reconstruction business and hospital spending may remain constrained.
The good news for Smith & Nephew is efficiency efforts are boosting profitability despite weak demand trends. The firm turned in 11% adjusted earnings growth in the quarter, or much higher than its 4% revenue growth. Also, cash flow generation is accelerating. In the first half of the year, Smith & Nephew generated $250 million in free cash flow compared to just $64 million in the first half of 2009. With cash flows usually accelerating in the last half of the year, the company looks well-positioned to hit our free cash flow expectation of just under $600 million in 2010.
Julie Stralow, CFA, is an equity analyst with Morningstar.