CNVVF - Smith & Nephew Getting More Interesting As A Contrarian Idea

2023-10-12 16:31:15 ET

Summary

• Smith & Nephew's shares have fallen over 20% this summer, despite ongoing improvements in the company's operations, as ortho stocks have been especially weak.
• The impact of GLP-1 drugs on the knee replacement market is uncertain; reduced obesity could reduce long-term knee implant demand but increase the eligible patient pool in the short-term.
• Smith & Nephew still faces challenges in its hips and knees business, but there is momentum with its cementless knee and robotics, while sports medicine and wound care are performing relatively well.
• Smith & Nephew shares look increasingly attractive as a contrarian call.

It’s been a cruel summer for ortho companies, and Smith & Nephew ( SNN ) has been no exception. The shares of this diversified player in ortho, sports medicine, and wound care have fallen more than 20% since my last update , exceeding the mid-teens declines at Enovis ( ENOV ) and Zimmer Biomet (ZBH), as well as the modest decline at Stryker (SYK); only Medacta (MOVE.SW), a small Swiss player, has shown meaningful appreciation over that time.

Whether or not fears of the impact of GLP-1 drugs on the knee replacement market are valid is a question I’ll address later, but these declines do seem to fly in the face of ongoing improvements at S&N. I do still have concerns about whether management can hit its operational improvement targets and whether management can close the gap in ortho to players like Stryker and Zimmer, but that seems more than priced into the shares and this is becoming an increasingly interesting contrarian play to me.

Will GLP-1 Drugs Kneecap The Ortho Sector?

At this point, I don’t think it’s much of an exaggeration to say that the Street is treating GLP-1 receptor agonists like Novo Nordisk ’s (NVO) semaglutide ( Ozempic and Wegovy ) and Lilly ’s ( LLY ) tirzepatide ( Mounjaro ) as wonder-drugs. Given the demonstrated impact these drugs have on diabetes control, weight loss, heart failure, and kidney health, that’s not an unreasonable stance to be honest, and these drugs will likely carve out a new category of “super-blockbusters” by the time they reach peak sales.

Now the question is what this class may mean for knee pain and the knee joint replacement market. Prior studies have suggested that these drugs can lead to reduced pain in patients with osteoarthritis and that makes sense – the knees are weight-bearing joints and I’ve seen estimates that each additional pound of bodyweight creates an incremental four to six pounds of strain for knees (it’s not great for hips or ankles either).

Novo recently completed a study (NN9536-4578) of semaglutide in obese patients with a specific endpoint targeting knee pain and its evolution through the study (in response to the expected weight loss effect). While the data have not yet been released, I’d be very surprised if there wasn’t a meaningful improvement here, and investors have already extrapolated this into reduced knee implants down the road.

I don’t think it’s that simple, though. Yes, reduced obesity will reduce wear and tear on knee joints and reduce some of the “supply” of future knee joint patients. Obesity isn’t the only driver of knee replacements, though, and there will still be degeneration in the joint as people live longer and lead more active lives in their senior years. What’s more, this could actually increase the patient pool, at least for a time – obesity is a risk factor for joint replacement surgery and many (if not most) orthopedic surgeons will refuse to operate on patients with BMIs above 35. Given the weight loss impact of these drugs, then, I could see this actually growing the eligible patient pool before leading to some reduction over time.

Meanwhile, Smith & Nephew Still Has Its Own Challenges

The possibility of an external force reducing the demand for knee replacements isn’t a positive, but there are other, more certain, issues that Smith & Nephew still needs to address.

The company’s performance in hips and knees has continued to be mixed at best. The second quarter was the first quarter in almost two years where the company didn’t lose share in hips in the U.S., as supply/procurement issues have improved. In knees, the business remains quite weak, with only Johnson & Johnson ( JNJ ) performing worse in the second quarter (Smith & Nephew has been last or nearly last in that market for a few years now). While the global picture is brighter, with the company actually gaining share in knee (even with the impact of value-based pricing in China), there’s still a lot of work to do here.

On the positive side, hip supply issues seem to be largely over. I’m also guardedly bullish on the company’s cementless knee, as the company does seem to be seeing actual momentum here. There’s also some momentum in the company’s Cori (or CORI) robotics business, with over 20% attachment in U.S. knee procedures and about one-third of Cori placements going into ambulatory surgical centers (which are taking share from hospitals, particularly for younger patients).

There could also be some challenges coming up in the Sports Medicine business. It looks like China’s anti-corruption drive is going to have some impact on the arthroscopy business in the second half of 2023 as capex equipment purchases are held up pending the resolution of a sweeping series of investigations. It’s important to note that Smith & Nephew has not been implicated, but rather this is a very broad effort across China’s healthcare sector that has effectively paused a lot of capex spending. I’d also note that the company is going to start seeing value-based pricing impact the business in the second quarter of 2024, and it certainly had a negative impact on the ortho segment.

Last and not least is increased competition in the wound care space. On the positive side, it looks like the company is gaining share in negative pressure wound care as RENASYS is winning GPO re-tenders and apparently taking noticeable share from 3M (MMM). On the negative side, reimbursement remains challenging in some U.S. markets and both Coloplast ( CLPBF ) and ConvaTec ( CNVVF ) are becoming much more competitive in wound care (and particularly in biologicals, the more attractive and higher-margin sub-segment of the wound care market).

The Outlook

It’s worth noting, I think, that Smith & Nephew has actually exceeded sell-side expectations for revenue growth in 2023, with both Q1 and Q2 modestly ahead of expectations and management raising its guidance to 6.5% organic growth (from 5.5%) after Q2/1H earnings. Although first half earnings were shy of expectations (about 6% at the adjusted operating income line), a lot of that seems to be tied to timing and management maintained full-year guidance for 17.5% margin (1H’23 was 15.3%).

I remain concerned about the competitiveness of the company’s hip and knee franchise, particularly given its less sophisticated robot offering, its lack of leverage to extremities, and the stated intentions of JNJ and ZBJ to improve their performance (particularly in areas like robotics and trauma/extremities). At the same time, companies like Enovis more aggressively targeting ASCs doesn’t help.

I’m less concerned about the other businesses. The sports medicine business arguably remains underappreciated, particularly the fast-growing ENT business (helped by growing adoption of Tula), and I still see attractive opportunities in areas like tissue repair (ACL and rotator cuff procedures especially) and navigation and imaging. Wound care is more mixed; I’m concerned about increasing competition and increased reimbursement pressure, but I like the recent momentum in negative pressure.

I’m still expecting around 4% to 5% long-term revenue growth from Smith & Nephew. Admittedly, that represents a step up from the trailing growth rate (around 2% over the last decade) and that may be too big of a leap for other investors to make, but I think there’s been actual progress in ortho (the big drag on growth over the last decade), and I’m still bullish on the other businesses.

On the margin side, I’m still expecting around two points of improvement over the next two years (EBITDA and adjusted EBITA) and I think the company could be close to 30% EBITDA in five years if it continues to execute on its self-improvement plan (a lot of which is based upon internal execution versus external help). With that, I still think free cash flow margins can move toward 15% over five years and toward 17% over 10 years, driving high single-digit adjusted FCF growth.

Both discounted FCF and multiples suggest meaningful undervaluation. By FCF it looks as though the shares should trade over $30, while growth, margin, and ROCE support a 3.5x forward multiple on revenue, or a nearly $39 fair value on FY’23 revenue. If I cut my revenue and margin assumptions such that revenue growth falls to 2% and long-term FCF margin falls to around 13% (consistent with an adjusted historical average) I get a fair value basically equal to today’s price, so it seems like the market is pricing in no improvement.

The Bottom Line

I won’t pound the table and insist that Smith & Nephew deserves the benefit of the doubt – a long history of poor strategy and weak performance in ortho supports doubt – but I do think expectations are now quite conservative. I want to see what management says about the market and its margin evolution with Q3 earnings (they won’t report margins, but they will likely comment on it) before getting more “officially” bullish, but this is becoming a more interesting contrarian idea.

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