Julie Stralow: Hello, I'm Julie Stralow, equity analyst at Morningstar. Today, we have Phil Cowdy here from Smith & Nephew (SN.). Smith & Nephew is one of the top innovators in the orthopedic device industry. However, shares have been constrained recently as a result of uncertainty associated with the orthopedic device industry, in general. At Morningstar, we see this as an opportunity. So, we think it's particularly timely that we have Phil here to talk to us today. Thanks for joining us, Phil.
Phil Cowdy: Happy to be here.
Stralow: Well, let's just dig right into it. The developed markets for orthopedics are at the center of a storm of economic, regulatory, and reimbursement uncertainty. So when you look at the market, what growth opportunities do you see in the developed world, in general, and then specifically, how is Smith & Nephew poised to capitalize on those opportunities?
Cowdy: Yes, storm is probably a good word for it. I think what we're seeing now is volumes on a cyclical downturn. They are softer than the long-run demographics more older people would push for, and I think pricing pressure is bearing down on us. Health-care systems are short of money, but more there are patients to deliver.
But I think in many conditions, you can still outperform the market. You need to deliver innovation. You need to deliver products which give patients benefit and particularly in this storm, as you put it, the innovation that gives the health-care system cost benefits. So in terms of Smith & Nephew, our research and development is driven to provide those two things.
So for example, in our U.S. knees sector, we grew last quarter at 5%, and the market was down at negative 3%. Why do we get the outperformance? Well, we have products in VERILAST, which is a bearing surface, which has a claim that it will wear for 30 years, benefit for the patients, and in theory benefit the health-care system because the patient doesn't have to come back.
And also VISIONAIRE, which is a cutting block, which saves hospitals time and makes the procedures faster. Again, it's a cost benefit to the health-care system, and the patient should have better alignment. So, I think it's about providing the right innovation to satisfy both of those, and if you have that, you can gain share.
Stralow: You spoke a little bit about pricing pressure, and pricing pressure is something that investors are talking a lot about in the developed markets. How do you see the pricing dynamics affecting Smith & Nephew, and how do you see that evolving in the future?
Cowdy: Yeah. We see pricing pressure. It's typically been running for some time at minus 2% to minus 3%. That's the type of level we see it persisting. It's one of the structural changes we believe has happened in our industry over the last sort of four or five years. I think how do we manage that? There's a number of ways. First of all, we need to bring products where we can get a mixed benefit, so these are products which offer the patient outcome and the cost outcome.
Secondly, as we look to our own business, we have to be ever more efficient in how we deliver to customers. So, we have to look at our cost of goods, where do we manufacture products? Can we do more in low-cost countries? How do we do our manufacturing? Can we drive costs out of the facilities we already have? I think as we look at our general and administrative expenses, our structure, how do we support our sales team? We have to make sure that that's sufficient. So, what we're doing at the moment is we've united two of our divisions together. That is part about being more efficient.
So, we're moving from having two human resources functions to one HR function, from having a big IT department to one satisfying just what we have. Looking at how many countries we're in and what infrastructure we have there, again, drives out the cost. I think those are the short-term benefits.
As you look longer out, we are putting more effort into how we design our products, such that as we design them we think more about the cost of delivery. For example, when we design a hip or a knee system, we design an instrument set that the surgeon needed to implement it.
Now, historically, we've had a different instrument set for every single hip or knee. Maybe, we can have a universal set so that we don't have as much capital tied up. So, all of these things. It's not just now; it's sort of a multi-year program to drive out the efficiency amid, as you say, the structural cost we see.
Stralow: One big area that seems to be like it could be the answer to many prayers is emerging-markets expansion. Could you talk a little bit more about Smith & Nephew's efforts to grow in those areas?
Cowdy: Yeah. With emerging markets, we certainly believe that there are significant opportunities. I think the size of the population, their wealth is very well-documented. In addition to that, those populations are clearly aging. Unfortunately, they are suffering some of the Western diseases, such as obesity, wearing-out joints, more trauma, diabetes, and so on which requires wound care. Those countries' populations are demanding high levels of health care, and the governments are putting more money into it.
So, we see huge fundamental benefits there. How are we addressing it? Well, we're investing more, and what do we mean by that? Well, we are very much focused on unsurprisingly the BRIC countries, the China, India and Brazil and Russia to a lesser extent. We are putting in place more sales teams. We have stepped up the amount of medical education we do by a very significant degree. These countries have many trained doctors, but they may not be trained in orthopedics. So, if we offer that training, they both benefit, and they get used to our products and the Smith & Nephew brand. Hopefully, they become loyal customers after that.
In addition, we are looking to tailor the products that we give there. If we just import Western products, the price points there will just be too high for the majority of the population. So, we are developing a range of products we would call good-quality products, but they come at a price point more appropriate to the mass market. If we deliver that, then we believe that we will get the growth that is clearly there.
Stralow: Right. You mentioned a couple of big challenges to entering the emerging markets, and education and pricing are big issues. So, realistically, what are your goals in the next five years to be in those emerging market countries that you mentioned?
Cowdy: Yeah. If you just take the BRIC countries, most recently our focus has been on China. We really entered China seriously probably about two or three years ago. We have a business now there of just under $100 million. We have a small business in India and a small one in Brazil. So, in total, around $100 million we had last year in those four countries.
We aspire during the next five years to increase that to $500 million. It's a big number, but we look at the potential. We look at our ability to execute against it and believe that it's a deliverable target for us.
Stralow: One other big bright spot for you is negative pressure wound therapy. Could you talk a little bit about the strengths that you see Smith & Nephew having there and what does the company need to do to take it to the next level in that business?
Cowdy: Yeah. I mean, negative pressure wound therapy is the newest of the advanced-wound-care areas. This is a technique where you deliver a mild vacuum at the wound face and could halve the time to heal hard-to-heal wounds. It's a very big marketplace. We entered it about four years ago. I think the initial component of our strategy was around delivering equivalent products to that which is on the marketplace.
I think now we are really moving into the next stage where we're going to bring a greater degree of innovation at this marketplace. Our background is in a wound-care company. We have been treating wounds for 150 years. We feel that over that time we know a reasonable amount about how to do it. And we are bringing the technologies around foams, around the healing of a wound cycle to play. On top of that, we have an absolute focus on what the customer wants not just the patient customer. What they want from negative pressure is something that essentially they can live with on a day-to-day basis. Ideally they can take out of the hospital and continue to treat themselves at home.
Hospital systems, they want ethical products, but they also want to come at the right price point. Again, we're focused on delivering those; these are simple products that you can take home. We want them to come at the appropriate price point, and then everybody benefits.
Stralow: Well, it looks to me like in the next quarter or two that you will be at a net cash position. What do you guys expect to do with that excess cash flow going forward?
Cowdy: Yeah. I mean, as you highlight, Smith & Nephew is a high-cash-generating business, and we have a strong balance sheet. In terms of our plans for the cash flow, I mean, first of all, it's all investing organically. We have touched on emerging markets. We plan to invest more in R&D to drive the innovation. After that we are looking increasingly at acquisitions.
We think that we also have the financial strength; we have the management strength to integrate and look for appropriate acquisitions. They aren't always there. Types of areas we're thinking of is that we are always looking at small bolt-on acquisitions, such as in technology. We're always looking at new products we can put down in our existing lines. We look at geographical expansion to kick start some of the things we're going to do in the emerging markets.
Then, finally, we see scope for larger-scale bolt-ons, particularly within the advanced-wound-care market and the minimally invasive surgery areas.
Stralow: Okay. Well, interesting times at Smith & Nephew. So, we appreciate you being here today and thanks for sharing your thoughts.
Cowdy: Great. Happy to be here.
