SNNUF - Smith & Nephew plc (SNN) CEO Deepak Nath on Q2 2022 Results - Earnings Call Transcript

Smith & Nephew plc (SNN)

Q2 2022 Results Conference Call

July 28, 2022 03:30 AM ET

Company Participants

Deepak Nath - Chief Executive Officer

Anne-Francoise Nesmes - Chief Financial Officer

Conference Call Participants

Patrick Wood - Bank of America

Jack Reynolds-Clark - RBC

Hassan Al-Wakeel - Barclays

Julien Dormois - BNP Paribas

Chris Gretler - Credit Suisse

David Adlington - JP Morgan

Presentation

Deepak Nath

I'll just draw your attention to the safe harbor statement on the slide that's about to pop up in front of us. So, it's a pleasure to be reporting the results of my first full quarter as CEO and also to be meeting many of you in person for the first time.

So as you can imagine, I've been spending these last few months getting into the detail of the business and building up a picture of how we can drive greater performance and value. So, before we get into the quarters numbers, I'd like to share my initial thoughts on Smith & Nephew's positioning, some of our early priorities and our expectations.

Smith & Nephew has many exciting opportunities with a number of factors that are lining up for us to take go to the next level of growth. Innovation is a key driver of value in our industry and this is a company with innovation at its core. I've seen leading technology in every aspect of the business in established products, in recent launches, and in the depth of pipeline across our franchises.

Secondly, the fundamental competitive positioning is strong. We have a clear right to win in all franchises. There are structural advantages that are distinct from our competitors and our proprietary platform technology with applications across multiple devices and procedures. And importantly, the delivery is good in two out of our three franchises that account for about 60% of our revenue base. So there's no systemic barrier to execution.

The challenges won't be surprising to you. Strategic execution in orthopedics still needs to improve. And our manufacturing and supply chain are not yet where we need them to be. Both our growth and our margin recovery have been held back as a result.

So I've spent some time going after the root causes. Although, there's already some work underway, we have now developed a new structured program of execution with a deep level of oversight that I know is required to deliver this type of program and at pace. This work is already stored in.

Turning to our results, I would say our first half performance was mixed. Wound and sports medicine continued to be on track whereas orthopedics was held back by execution and supply chain challenges, and of course the impact of China VBP.

We've adjusted our 2022guidance reflecting these supply chain challenges and the difficult macro environment. Anne-Francoise will walk through the Q2 and H1 results. And then I will come back and talk in more detail about our comprehensive action plan for the future.

Anne-Francoise?

Anne-Francoise Nesmes

Thank you, Deepak. And I agree with you. It's certainly really good to be in person for the first time in two years, as far as I'm concerned. So thank you for making the effort to come. But as Deepak say, now start by going through the detail of the second quarter.

So growth in the second quarter was 1.2% underlying. The slow growth than we saw in the second -- than the first quarter, mainly reflected a number of known factors. These were one fewer trading day than in 2021, the implementation of China VBP in hips and knee, and lockdowns in some region of China, which particularly affected our sports franchise.

Looking at our growth by geography, the U.S. was the fastest grow region at 2% for the quarter as a whole. Emerging markets grew 0.8% reflecting the headwinds in China were offset by strong growth in India, The Middle East and Latin America, another established markets were flat reflecting a slow quarter in Asia Pacific.

Going into the detail of the franchises, overall, orthopedics revenue fell by 1.1%. As I mentioned earlier, VBP implementation was a significant headwind. If we exclude China, orthopedics grew by around 2%. In reconstruction, knees grew 2.7% and hips declined 3.7%. As well as the VBP impact on our out of U.S. revenue, the quarter reflects the need for improved execution and supply chain management that Deepak will talk about shortly.

We also continuing to roll out on cementless knee in the U.S., and while it's too early to move growth significantly in the quarter, we do expect to become a more visible in the second half. Other Reconstruction returned to double digit growth and robotics growth was well ahead of the overall segment. Our offering is continuing to develop, the first CORI assisted hip and cementless knee procedures were completed in the quarter, and in second half, we expect to become the first company to offer robotic-assisted knee revisions.

Trauma & Extremities declined 6% and were slow across most regions. As you may be aware, we opted not to participate in the broader rollout of the provincial trauma tenders in China, which explained part of the decline in the sales. Sports Medicine & ENT grew 1.9% with Joint Repair gained 2.1 and Arthroscopic Enabling Technologies declining by 0.5%.

As I mentioned earlier, Sports Medicine was particularly impacted by the impact of COVID outbreaks in China. Without China, the franchise growth would have been around 5% with 7% in Joint Repair and 2% in AET. Otherwise, the drivers of the business were very similar to the first quarter. The recovery in knee repair market continues to drive our growth in established markets as level of physical activities returned to normal.

Also, we have recent launches such as FAST-FIX FLEX and FASTSEAL, which continue to track ahead of our plans and are making an increasingly important contribution to the growth. As we mentioned before that availability of electronics remains a challenge and this is continuing to be a headwind in at AET. ENT growth of 11.2% reflects continued post-COVID volume recovery also helped by successful price increases in the U.S.

And finally, Advanced Wound Management grew by 3.8% within that Advanced Wound Care grew 3.3%, driven by good growth for my infection management portfolio and a strong quarter in the Asia Pacific region.

And in July, we launched a WOUND COMPASS Clinical Support App, which is a tool to help healthcare professionals assess wounds and choose the most appropriate treatments. It's a great example of our cross franchise digital capability and also the value of our broad evidence backed portfolio. Bioactives grew 2.4% in the quarter driven by our skin substitutes portfolio and Advanced Wound Devices grew 7.9% with continued double-digit growth in PICO.

I'll now move to our first half financial results. I'll start with revenue, which was $2.6 billion in the first half up 3.5% on underlying basis compared to H1 2021. Reported revenue was flat including a foreign-exchange headwinds of 350 basis points given the strength of the U.S. dollar against other major currencies.

And as you can note here the M&A effect was minimal. As you seen the chart, Sports Medicine and Wound showed mid single digit underlying growth. And as in the second quarter, all of these growth rates reflect one fewer trading day than in 2021.

Moving to the summary P&L, the gross margin in the first half was 70.9%, which is an increase of 30 basis points. A variety of factors that I play here and are important to note, inflation is offset by some price increases, and a tailwind in the first half from the timing benefit of our hedging strategy.

The trading margin, however, was lower at 16.9% compared to 17.6% in 2021. And that comes from high SG&A costs, where we felt the inflationary pressure in freight and logistics that you see across the economy. And we've also increased commercial activity as patterns of engagement with customers return to normal.

I'd also like to highlight that in line with our strategic commitment to innovation, we've maintained R&D ratio at 5.7%, and continuing down the P&L, adjusted earnings per share declined by 2% to $38.01. You'll notice, of course, that's ahead of the development in our trading profit due to a lower tax rate than in the first half of last year. And the interim dividend $14.04 per share is unchanged from 2021.

We generated trading cash flow of $154 million in the period with trading cash conversion at 35%, that is lower than in 2021 under decrease was primarily driven by higher inventory, which you see in the working capital outflow of $304 million. Part of that is that we've increased pot buying of raw materials and component to secure supply and mitigate the risk of shortages. There was also a further effect from the phasing of other working capital movements that we expect to unwind in the second half.

And moving to the balance sheet, net debt ended the half at 2.4 billion as shown on the slide. That's an increase of $355 million in the first half with $89 million coming from the acquisition of Engage Surgical in January, and $133 million coming from share buyback. The effect of all of that is that leverage ratio finished a half at 1.9x adjusted EBITDA, which is very similar to recent levels. And I'll finish with the guidance for 2022.

Firstly, we're continuing to target underlying revenue growth of 4% to 5% for the full year. The first six month, as you've seen growth was 3.5% underlying even despite the COVID restrictions in China. And we continue to expect stronger growth for our business in the second half. For the trading margin, we expected to be around 17.5% for the full year. This reflects the prolong and higher impact of the inflationary environment on our business particularly in freight and also reflects continuing external supply challenges.

Clearly, we are continuing to manage input cost, but we're also maintaining critical growth investment in the future like R&D, and we do expect some of that to have an impact on our margin.

And with that, I'll hand back to Deepak to cover our action plan.

Deepak Nath

Thank you, Anne-Francoise. So having covered our first half performance, I want to share with you my assessment as Smith & Nephew and how we are moving forward. So I'll start with the opportunities. I talked about our right to win and that is critical because it gives us the confidence that we'll be able to deliver our growth aspirations as we improve our execution.

In Orthopedics, that right to win comes from our portfolio and our technology. On the portfolio, we now have a full product range across hips and knees that we can offer to our customers. There were major gaps in the past, but they've now been closed and we're now starting to open a gap of our own against peers. For example, with the engage cementless Uni knee, and in some ways our product range is too wide, and I'll talk about that later.

Our Implant Technology is unique and differentiated. We have the kinematic profile of the journey to a knee with motion closer to the natural knee than competitive systems. We have a proprietary materials technology in OXINIUM with applications across multiple devices and outstanding long term outcomes. There's the OR3O hiccup that takes that material and applies it to the dual mobility approach.

And in Trauma, we're completing our highly competitive EVOS plating system with large plates. And that gives us a comprehensive and easy to use system that addresses all fragmented surgical needs. And there is a robotic-enabling technology platform CORI as well as the economic and portability advantages of CORI. It was designed from the beginning to be able to work on a range of other hardware and in a range of indications.

We're just still at the start of the plan functionality and you'll start to see unique indications and assets added as early as later this year. And in fact, an update to what Anne-Francoise was just mentioned just overnight, we got approval for indication on the LEGION knee that you've telegraphed, so really good development for us as we continue the journey with CORI.

In Sports Medicine, we also have a complete offering for our customers with joint repair, the arthroscopic tower and customer service. So, most competitors either have gaps or are just selling equipment without the deep relationships in this segment. We have leadership positions in the various segments including being the number one company in enabling technologies and biologics.

And we have scalable synergies with other areas such as through CORI and cross-selling opportunities in the Ambulatory Surgical Centers. And in Wound, we have the deep broadest portfolio offering solutions across all key wound types, bringing together foams, devices, biologics, and I just heard from Francoise digital.

We're leading negative pressure platform with huge potential for market expansion. And we have a catalog of strong evidence across our categories, showing proven clinical outcomes and economic value. And that sets us apart from the low cost segment of the market.

So let me turn to these two franchises, Sports & Wound. We're demonstrating that as a company, we're more than capable of capitalizing on the advantages we have. As a reminder, as I mentioned, 60% of our revenue comes from these two segments.

Sports has been outperforming the market for many years, and when I look at why? I see commercial excellence built on a deep understanding of customers, and a precise targeted approach for engaging with them. And there's also a steady stream of innovation across procedures and a successful integration of assets that we've acquired.

The Wound team has done many of the same things as that franchise has accelerated over the last few years. We've made good use of our structural advantages by focusing on portfolio strength, breadth, and evidence based selling. We've also executed well on high growth acquisitions, like skin substitutes and leaf. And importantly, we've successfully driven margin improvement at the same time, so both are well placed to continue in the same way.

In Sports Medicine, we've refreshed the capital equipment in the last two years and added a new innovation platform with biologics. And in Wound, there's still an opportunity to deepen the penetration of advanced treatments. With wounds today either not being adequately treated or not being treated at all. And finally, as I mentioned, there's an exciting pipeline across these categories.

Turning to Orthopedics, that's clearly where our key challenges are. It had been a long-term outperformer, but has trailed the market certainly since 2020. A key priority for me has been to understand why that happened, and what we need to do to get back to winning. The aim in orthopedics is to be a procedure innovator with best-in-class implants as I alluded to and paradigm changing enabling technology on the CORI platform.

As you know, we had a major product gap not having a cementless knee hurt us for a number of years. The fix for this is in place with the cementless Lesion that's rolling out now, wasn't perceptible in first half results. As Anne-Francoise mentioned, we expect that to start to register in the second half and going forward.

There are more structural factors as well; however, and that's around execution and in supply chain. In terms of execution, we've become more complex and less agile than our larger peers. Both in terms of our portfolio and the ways in which we work. For example, we're still supporting multiple hip stems and knee systems in parallel when peers are increasingly focusing on just one, the one family.

We also hadn't recognized that operations and commercial had become disconnected when they need to be working even more closely together for top class execution. The result is that supply is not always well aligned with commercial needs. And finally, capital management has not been efficient. Instrument sets are not always optimally placed with full sets at centers that may not need them, and not enough sets elsewhere. The financial effects is that asset turns are lower than they should be, and on an investment that's about half of our CapEx.

So let me turn to supply challenges. In manufacturing and in supply chain like everyone else, we're feeling the effects of increases in raw materials and freight across our businesses. But it's also apparent that our current solutions to the Smith & Nephew specific issues, and that's in orthopedics, not in wound and sports aren't working fast enough. We're addressing the root causes sufficiently.

So, we've made good progress in addressing the operational issues in Memphis. That heard us in '21, for example, staffing shortages that we alluded to. The fundamental efficiency and reliability of our supply chain is not where it needs to be. The effect is not just the outright shortages that we saw last year and continuing into this year, but also that reps have spent far too much of their time managing existing customers rather than acquiring new business. For example, in the case of trauma, the majority of our reps are spending 40% or more of their time managing logistics and inventory.

These challenges weren't always there. Some were made worse by COVID and for others, the disruption of the pandemic hit problems as they developed. We know the importance of getting this fixed, and the work is underway. Building on our previous work, the team has put together a comprehensive 12 point program of execution in the last two months that cover the biggest opportunities for our company.

These are the highest level regaining momentum in orthopedics, really fixing orthopedics, across recon and robotics and trauma, improving productivity throughout the supply chain and of course, further accelerating Sports & Wound. The elements have been worked out in quite some detail and are backed by robust structures for accountability and I'm taking personal oversight. I'll come back to that in a moment.

For now, I wanted to give you a bit more detail on orthopedics and some of the things we're working on are picked out on the slide. First we're rewiring and commercial delivery. There are a range of aspects to this, but examples are a greater focus on differentiate products and procedural innovation, aligned incentives, and a more detailed customer segmentation.

Secondly, we're going to streamline our portfolio by reducing the number of implant systems we support in a category. For example, in hips, we go from 11 systems down to 6 that will include renewing our sales efforts on the priority brands and will bring benefits from simplification and great focus throughout the organization.

We also will improve our asset utilization particularly with instrument sets. We're establishing clear principles on where we prioritize placement, where we use consignment and where we use loaners and rolling out analytical tools to support management. This work has started already.

And where we rebuilding the demand planning process, closer collaboration between operations and commercial will address short-term tactical supply chain decisions and longer-term signals to better align production with market needs, there's a lot more behind this and I'll keep you updated on progress and provide additional detail in the coming quarters.

So turning back to the program, some of you know this I've driven this type of program successfully before. In my experience, a big part of the success of this work will be having the right governance and accountability to ensure that the plans are followed through and the changes become a normal part of how we operate?

We already have refreshed leadership in commercial and operations with area specific experience and track record. You already know Brad Cannon, our Head of Orthopedics or Head of Orthopedics and Sports. And of course, the orthopedics leadership team that report into Brad.

On the operations side, we have Paul Connolly, who's our Head of Operations. And last summer we brought in a new Head of Orthopedics Operations and rebuilding other important areas. Our new Head of Orthopedic Operations has driven similar turnaround ops turnarounds elsewhere, and our Head of Supply Chain, a new head of supply chain previously ran an optimization process in another orthopedics business.

And our new site leader in Memphis also has deep orthopedics expertise. On the actual delivery, in terms of these programs, this program that I talked about, there's a responsible named owner for each area, and we've established a high cadence of interactions with the responsible teams. That's fortnightly meetings under my direct oversight.

Each area also has specific action plans with meaningful forward indicating KPIs to track progress. And again, ensure accountability with and transparency reporting -- with reporting going all the way up to our board. Getting the full benefit of this work will take some time. We'll start to see operational benefits from some elements quickly such as asset optimization and further benefits will continue to accumulate over the next two years.

As you've heard me say, there are more opportunities than challenges with Smith & Nephew. This is a great company with a great outlook, and I believe we're not far away from showing this externally in all aspects of our business. There are challenges we need to address, but things are starting to line up even in orthopedics where we're poised for an inflection.

We have an outstanding portfolio already, and we're bringing the next wave of innovative implants to market like the cementless knee, The Engage Uni knee, EVOS LARGE, and the next-generation shoulder. We have enabling technology leadership already with CORI and the unique platform extensions to come. I talked about one of the just now.

We have a revitalized management team, and we're getting on with rewiring, literally rewiring our commercial delivery with energy and at pace. I see these initiatives as part of our transformation journey as an innovation led portfolio medical device company. And they're aligned with the strategic framework that we previously communicated to strengthen, accelerate and transform.

As these foundations are fixed in orthopedics, it will free up our people and capital to take much better advantage of our clear right to win. We'll keep in investing in innovation and continue with M&A across our portfolio. Sports Medicine & ENT and Advanced Wound Management are already showing what we can achieve when we combine leading technology and getting the execution right. And I see significant opportunities to invest further -- well performing franchises.

I'm truly excited by what's ahead and now we'll take questions.

I think Patrick was first with his hand up, Charles.

Question-and-Answer Session

Q - Patrick Wood

Obviously, it's Patrick with Bank of America. Just three quick ones, I guess. Short term, the supply chain, let's call it Q2 situation. It sounds like Memphis got better. So maybe a little bit of details in terms of the other hiccups, I guess, outside of Memphis? So that's the first one.

Second one, appreciate, might be a difficult topic, but midterm margins and any commentary there given a tougher jumping off point, let's say, given the environment?

And then last one, you touched on it in terms of the orthopedics work that you're looking to do. Am I taking the right sense here that you feel like you've got the right people in place, whether it's below the leadership team, like further down, and it's more about intensity and culture, or do you feel that further down the structure there might be -- need to be some new people coming in it's how you want to characterize the two there?

Deepak Nath

Thanks Patrick for the questions. So first, let me talk about the Memphis part of it. So as I noted, in terms of product availability in orthopedics, we indeed made -- have made improvements in Memphis. The biggest issue we faced last year was around staffing. And we're largely on the other side of it, knock on wood, right? You never say on the other side of staffing anywhere ever in this environment, but we've lapped that.

The issues, as I find in terms of product availability in orthopedics is supply is a piece of it, but the rest of it is in our hands. The connectivity between commercial and operations is not where it needs to be, which has led to product availability challenges, and one of the highest levels of inventory in this business. So we've got stuff to put it simplistically, it's in the wrong places and what we're doing. We didn't just get there overnight. It got there over a period of time because our wiring wasn't working as intended.

So we understand that problem now. So, we've got to fix, continue to improve our Memphis operations, but we've got to fix this wiring. And that's the work that's underway so that we can better connect demand at an account level to a production plan. And in the near-term, when I talk about how we improve asset utilization, we're going to embark on a structure program to move inventory and sets from low consumption accounts into higher consumption accounts.

So we've been doing this sporadically in certain places, but what we're take doing is taking a step back undergoing a structure program and looking at this globally versus kind of optimizing locally. And we believe over the next two quarters that will have a benefit by effectively putting stats where they can be consumed. And that will free up some of the sometime from our reps.

Related to that, what I believe we've underestimated and we knew this at one point, but somehow we've lost our weight on the importance of logistics, particularly last mile logistics in orthopedics. So we are embedding logistics experts in our commercial teams at the right level of aggregation.

Let's call it metro areas. That's the change to how we've operated in the recent past. So that'll help offload all of the logistical burden that's now falling on reps onto people, who are trained in this area and who are able to take, bring a right level of focus. So that's the first answer to your question.

So regarding indeed the difficult topic of second half of this year, what we see -- we had obviously plan for a certain level of inflation and inflationary effects at the time we set our budgets and our guidance. What we're seeing is significantly higher than our worst case scenarios that we've modeled.

And when we put that into context with other factors and where we see the inflation and pressures, it's we've called out freight and distribution, but there are other impacts to that elsewhere as well. So when we look at the add-up and we see the macro factors lining up, believe the responsible thing for us to do is to call out how we see the business evolving with the risks? So that's why we've taken the place we've taken.

Now in terms of the leadership team, what I want to emphasize, of course, some of you have met Brad, we've given him expanded responsibilities. He was previously responsible for just for sports, but now he's also responsible for orthopedics, but those are distinct organizations underneath that. What I've called out is significant changes, thoughtful changes we've made in commercial, in franchise management and in operations, not only at the one level that reports in the Brad, but a level or two below that.

Many of these folks have just now become effective in their roles. I mean, the average tenure for the new folks are between 6 months 9 months, something like this, right? So they've just now come into place, getting acclimatized and starting to really impact the business in the way that we've hoped for them to be.

So in my assessment, we've got a good team in place. That's experienced. They're drawn from the industry. They know what good looks like, and they're bringing those best practices into it. And these are people who've joined us understanding the challenges that we have, right? They want to come into this building because they believe in the product portfolio. And I can tell you personally having come into this I was struck by the strength of our portfolio. This is not what I expected to find coming into it as an outsider into orthopedics.

And some of the folks who have come and joined us from leading companies are drawn to that and to our culture. So I feel very good about the team, several levels underneath in terms of the capability, the temperament, the culture that we want but want to change orthopedics. I also want to at this point to call attention the fact that we've got a challenge in orthopedics, but sports were working well, when were working well, we've got the right culture, we've got the right execution, the right folks, as I mentioned, combined with the innovation.

Anne-Francoise Nesmes

[Indiscernible] to the mid-term guidance, which was also some…

Deepak Nath

Oh, yes. Sorry, mid-term, I focused on this first half. Yes, the jump off point of course is more challenging, and we are going into an uncertain -- we are in an uncertain environment with unprecedented macro factors. We're focused on doing the things that we need to do to secure that three year plan that we previously outlined, so right? Has it gotten harder? Absolutely, the jump off point is different. But having said that, the things that have outlined in orthopedics, the things that we're doing around productivity, and margin expansion and around accelerating wound and sports, I believe are the right things to be doing and then most we'll see how that plays out.

Jack Reynolds-Clark

Jack Reynolds-Clark from RBC. On the Sports Med in China, is that more in the demand side or the manufacturing side? And this feels like a situation that probably won't improve without a change in sort of approach to COVID from the Chinese leadership. So is there any opportunities here to kind of get ahead of the game? And then just another quick question coming back to the guidance. So what level of inflation is already baked into guidance further or the revised guidance for your year? And what specifically has worsened particularly in the last two quarter?

Deepak Nath

So I'll take the first one. I'll tee off the second one, and I'll hand over to Anne-Francoise. Is that good? I'll give you the hard questions, Anne-Francoise. So, on the first point regarding Sports Medicine, the impact indeed is from the lockdown. It's not a manufacturing related topic in terms of specific impact to China. It's a demand topic, right?

In orthopedics it's VBP, so just wanted to contrast the impact of China across those businesses. But there are supply chain challenges in wound and in sports as well, they're related to a mechanical components and chips. Those are supply chain, but they're not specific to China. They're just large across the enterprise. So that's the thing that addresses your China question.

In terms of the inflationary pressures that we see as I mentioned where we're seeing a higher level than forecast impact is on freight and distribution. And that's not just us. I mean, it's the nature of our network, right? We feel it as we do, but it is an industry-wide topic and we'll see how things evolve, but if you wanted to comment more than that?

Anne-Francoise Nesmes

Just give a little bit more color. I mean, clearly I had and we'd spoken about having done a range of scenarios, but things have tougher and since we've spoken -- there's been various geopolitical tensions, as we know. Freight is a key element for freight on warehouses. And just to give you a feel, our cost have gone up by 40% year-on-year. So that bays one of the key element.

The other of course is people. And I know we'd spoken about, we have done our salary using the beginning of the year, but there is a cost or link to cost of living. There is a cost as you retain people as you recruit. And that is flowing through although it's a smaller component. And the smaller one, which I think that actually we've signposted quite well is raw materials. That is a smaller limit.

But again, you were talking about the microchips just now electronics have gone up by 38%. I mean those are significant shifts that many industries are facing, and that's what we have to adjust as well. And we are working hard to offset as much as we can, but some of it will flow to the bottom line.

Operator

[Operator Instructions] Our first question comes from Hassan Al-Wakeel of Barclays. Hassan, please go ahead.

Hassan Al-Wakeel

Hi, and apologies if these questions have been answered. We've been on other management results calls this morning. Firstly, Deepak thanks for your update. I wonder what you put the historic under performance of the business down to. How do you think execution will change going forwards? And should we expect a meaningful resumption in M&A activity?

Secondly, where is cost inflation running at for the business? Where was it for the first half? And what is your expectation for the second half? And could you break out the margin bridge for the year and if it's just the 125 basis points that is changing goal, if indeed it could be anything else perhaps VBP getting worse?

And then finally, just following up on the mid-term targets, could you walk us through the margin bridge to 24 where you see the key opportunities and the key risks in light of what you've talked about today?

Deepak Nath

Sure. I'll call in Anne-Francoise for the second part of your question, but let me take the first here Hassan. So, as I indicated in my presentation, the execution related issues have been in Orthopedics, in Sports and Wound. We have been executing while we've got a great portfolio and we've got the results to demonstrate that.

In Orthopedics, as I look back on it, it's a -- fundamentally, we've had in the past portfolio gaps that have been set us and have impacted our commercial performance. As I mentioned now, we've closed those gaps. We've got full range in hips and knees across families, but we've got a full range.

Andin CORI we've got a platform that's still in the early stages ofin terms of functionality and indications, but we're adding to it including most recently overnight. So that's a change from the past where we now have a portfolio, and we've got enabling technologies to drive growth.

The other piece of this is the connectivity between commercial and operations that account for the product availability challenges that we see. That really has hampered us. It's hampered our growth as our reps, focus on inventory and logistics challenges and serving existing customers rather than going out and acquiring new business. That's one example of the impact of that.

The second is the fact that we've got high levels of inventory, we've got product in the wrong places if you will, right. We haven't been good. We haven't had the process of ensuring that we're matching our supply and availability to customer needs. That's a process topic. It's an end to end topic that connects customer demand to a production plan, and we haven't gotten that right.

I don't believe we were ever particularly good at it, but we were okay for the scale of business we had COVID really impacted that. And that's had a significant impact on us over the last couple of years.

So the good news for that is we know what the issue is. We've begun to work on addressing the issues. It's a process thing. There's not some big IT spend we've got to do. There's not some big structural barrier to us improving that we know what we need to do on a good path to getting there. So that's the second piece of it that we're working on Hassan.

So I think I addressed your first part your question. On inflation, I think is looking for a breakdown in terms of the levels. I'll turn to Anne-Francoise to kind of comment some of it, which we covered in the last question, but perhaps you weren't on for that part of it. So Anne-Francoise, if you wanted to…

Anne-Francoise Nesmes

I guess in terms of there were two parts to your question, Hassan, and good morning, two parts, the first around the inflation in H1 and H2. As you can see, just looking our trading margin there's an impact on the trading margin is down year-on-year. And when you look at the elements of the P&L the inflation in the cost of goods line is not as apparent as you would think, because actually on the face of it, our gross margin is, is improving.

There is inflation starting to flow through, as we are selling material that has been built on a higher cost base that is flowing through, but that's offset by the timing benefit of our hedging strategy for an exchange perspective. But you can see the cost increase in SG&A which I referred to earlier, which is significant. And that's where we see the freight on warehousing costs we we've talked about.

So that has an impact on H1, and we expect that to continue to increase in H2 particularly through the COGs line. So when we pull all of that together to your question, what does that mean for the year? We had talked about three, I think levers, clearly when we gave the initial guidance, we talked about the inflation being a headwind, and you refer to the 125 basis point we talked about, and we talked about quite rightly, as you said VBP, which we mentioned at 60 basis point.

VBP is about our current estimate is in about the same position, probably slightly better because of the delay in the first few months of the year. So that's no material change in the food year. What has changed is really our assumptions around inflation, which is probably a hundred basis point higher than what we've assumed. And that's really where we are and the reason for the change to our guidance.

Now, offsetting that, we are and we have taken price increases. So, price is delivered we can push, but as we've always said, we cannot offset all of the price increases. And we also continuing the savings and the productive improvements we'd had planned. So the real, the change is that macroeconomic environment and the inflationary pressure.

And therefore, that leads back to the midterm items on the opportunities as you see them Deepak. And that was our last…

Deepak Nath

That's right. I guess to repeat Hassan what I indicated earlier. Jump-off point is of course, different now than maybe forecast. But in terms of the steps that we need to take to achieve our midterm guidance of 21% margin, and 4% to 6% underlying organic growth, the steps we need to take in terms of fixing orthopedics and enhancing our productivity and accelerating sports and wound are the things that we are working on are the levers that we have to pull in order to get there. And what we now have is a program under which these steps will be executed in order to get there. So when focused on doing that.

You asked about M&A, it previously would communicate in our strategic framework or strength, accelerate and transform that M&A would be a component of that. And I do see M&A being a component of it. As I mentioned, in some ways, we're a tale of two cities to invoke an analogy. We have to fix orthopedics. We know what the issues are, we're working at pace to fix them. But then we have 60% of our revenue base two out of our three franchises. They're actually working very well, where all of the elements are combining and working as they should. And so, we see opportunities to further invest behind that.

Hassan Al-Wakeel

That's very helpful. I guess, what I was trying to understand is the margin bridge between the 17.5% and the 21% by 2024, are you able to unpack the key components of that, please?

Deepak Nath

Sure. I think this is something that, I mean, I'll give you a top line answer, maybe follow-up with you. So, the big contribution there is the impact of growth. As I mentioned from orthopedics coming back to levels that we've targeted, we see us -- we expect a step up in the second half of the year. Some of that is the seasonality of our business, right?

But in general, on the back of not only seasonality, but product launches, we expect to see a step up in growth. So that's one part of it. And we see that continuing as we see the full impact of things like our cementless knee, getting traction in the market. CORI placements driving for the utilization of and pull-through of implants as we bring that forward, Engage our unique compartment knee getting traction in the market.

So, there's quite -- when talk about factors lining up, it's not any one factor that's particularly huge. It's the combination of these factors of the, add up of these factors that I believe is going to drive the inflection point in orthopedics. So the big component as we walk across from 175 into 21 is the impact of growth.

And then of course, in terms of margin, we need to see in productivity we are continuing the work to drive efficiency into our factories, the big opportunities in Memphis, as I mentioned, there's good progress along the way. But it's -- I didn't mean to signal that all the work has done. It's definitely continued impact of the initiatives we have in place around productivity that we expect to see.

And then of course when I talked about the opportunities in orthopedics, we see really good opportunities in wound and in sports medicine. On the wound side, as I mentioned, as I coming into the Company, I'm struck by the opportunity to expand the market, to drive penetration of some of our products, for example negative pressure, broader adoption than it's currently the case in procedures, and we're very well positioned to do that.

And the portfolio of breadth we have when we look at foams and we look at dressings, and we look at the biologics, those are skin substitutes. Those are all great products, great outcomes, great clinical data that underpin them. So, we see true opportunities to accelerate and I mean, I've called out negative pressure previously. So that's the other aspect of this. And add up of all of these I believe will -- if we execute this right, which we are well on the way to we will get to the 21%.

Operator

Our next question comes from Julien Dormois from BNP Paribas. Julien, please go ahead.

Julien Dormois

I have three, if I may. So, first of all, your comment that you would expect growth in the second half to be much stronger than in H1, so it would be interested if you could walk us through what are the main areas in terms of orthopedic, sports medicine, and when management that would explain the step up, that would be helpful please?

Second question relates to the recent announcement by one of your main competitors in wound management 3M that they are thinking about spinning off their healthcare business. That's typically the sort of situation where such a company starts to be more aggressive on pricing to make the bride look more beautiful, if you see what I mean. So are you worried that something like this could happen in the next two quarters and impact the recovery in your own management business?

And the third question is the housekeeping one. Just curious, what was the ethics impact on your margin in the first half? And what we should factor in for the full year please?

Deepak Nath

Great, Julien. So the growth in the second half, maybe I'll have Anne-Francoise will walk you through bit of the detail that we see. But just to kind frame the answer forH2, the levers I mentioned just previously on the orthopedic side, what we see is continued placement of CORI, of course, we're tracking not just placement its robotics is really a means to an end, it's ultimately to enable procedures and to drive implant.

So it's thoughtful placement of CORI and the impact not only of Engage Uni, the LEGION CONCELOC on their own, but also the impact of pull-through of the rest of the portfolio on these. So, these are in orthopedics, three of the drivers. EVOS LARGE launched recently, and so that completes or brings our EVOS family to a place where we can sell the portfolio.

Of course, the impact of that will be felt over time, will start to see it in H2, but really the bigger impact will be into 2023. So that's the orthopedics picture at large. And in sports and I just make comment on sports, think I've said a lot about wound. REGENETEN, we have highly, highly differentiated offering within sports. We see that as a continued driver of growth in that business, we also have great products, a great portfolio.

As I mentioned, we are the leaders in enabling technologies there and in the tower. So, we continue to execute on all elements of portfolio in sports, but I did want to call out REGENETEN. So, those are the factors, if you want to color that Anne-Francoise, a bit or –

Anne-Francoise Nesmes

No.

Deepak Nath

So the impact of 3M, the announcement, of course, it's still relatively off the presses. So our top-line is we are going to be monitoring the impact commercially, obviously carefully in the near-term. We expect to go about our business and go about executing as we have. In terms of price pressure, I would want to speculate how that's going to unfold, but I strongly believe in the differentiation of our portfolio.

Our strength comes from the breadth we have across all the categories that I mentioned, but actually within the category, each of these categories and the differentiation that we have in some of our, not only the lead products, but the second third tier products, not tier the value judgment. The secondary and tertiary products within each category are also themselves differentiated.

So I'm confident in our portfolio, I'm confident in our differentiation, and I'm confident in our team's ability to execute where we have been doing quite well in that regards. But obviously, we'll be monitoring the posture and how things evolve there in the field. And in terms of FX, impact, I think you've made a comment already, but I'll let you color that a bit Anne-Francoise.

Anne-Francoise Nesmes

So in the first half, there was a positive time when in the gross margin, in particular, as we see the timing benefit of the fact, we hedge on to remind everyone, 50% of our revenues are in U.S. dollar, but actually 75% of our cost base is in U.S. dollars. And we hedge 12 months in advance for some of those costs. So clearly, as the dollar strengthen that quickly, we do see the impact flow through the revenue much faster than on the cost as the hedging protects us for a period of time, but of course that starts on winding at some point.

So when we look at the effects for the full-year, we probably expect sort neutral or slightly positive impact, but I hate doing forecast on FX. I'm not a trader in FX, and going to knows where the economy is going. So, at this point in time with current FX, we think it's like in neutral, shall we say? And as you look into 2023, we, we estimate a headwind of about 40 to 50 basis point on the trading margin in 2023. So, sorry, I am expanding the question slightly.

Deepak Nath

I hope that answers those, your questions, Julien.

Operator

Thank you. Our next question comes from Chris Gretler from Credit Suisse. Chris, please go ahead.

Chris Gretler

And I have two questions. First, I'm a bit surprised by the magnitude of a fixed this orthopedic business required and could you maybe elaborate on how that's going to impact your midterm growth ambition? I think they are still 4% to 6% particularly in light that you intend to streamline your recon portfolio. Did I hear that right that you are aiming to reduce number of families knows from 12 to 6, that I think know probably has not quite a meaningful impact on the growth outlook? And I guess will be similar. Could you maybe elaborate on that specifically in orthopedics and maybe in general, how that affects your overall top line growth ambition?

Deepak Nath

Sure. So our growth ambition remains unchanged. What I'm describing is how we intend to get there. In terms of the orthopedics side, you mentioned the reduction in family on the hip side and in knees we don't have quite that many systems. So the magnitude of the change is going to be different. There's going to be work required to complete our family. So there's, this is not a lever for the next two quarters or three quarters is more over the medium term that we've talked about.

But in terms of our growth aspiration orthopedics, I strongly believe with the actions that we've outlined we are going to get there. And even in this quarter despite the impact of China, we were on the low end of that corridor that we indicated. So, what I want to highlight is or we expect to be on the low end of that quarter. So, the actions we've described are the means by which we're going to achieve the growth aspirations that we've laid out.

Chris Gretler

Okay, that maybe helpful.

Deepak Nath

So, I mean, just to accentuate again, thank you Anne-Francoise, the points that I've made in terms of the factors lining up. We see great potential in CORI, as a platform that is a different paradigm. We're very pleased with the reaction, the feedback from surgeons who've used it of course you get a spectrum of opinion. But we really are quite encouraged by the early results.

And I just want to remind everyone that we're at the start of that journey. So, we've added indications to it. It's also about adding functionality, not only in the knee, but also in the hip where we're really at the very, very beginning of adding functionality of on CORI for the Hip. So the remodeler that we launched last quarter is the first step along that journey.

So, that innovation and it's important that we've maintained the level of investment that we've called out and innovation is the lifeblood of our industry. Its core to what we do at Smith & Nephew. We've got a great set of differentiated products across our franchises on the back of the innovation that we have done over the course of time. And so, we plan to continue that investment that will be a driver for growth.

So I talked about CORI and of course, on the implant side it's The Engage Uni knee, it's LEGION CONCELOC and of course, journey two that continues to lead the way. OXINIUM is a highly differentiated technology. The data that we have, the 5 and 10 year data on OXINIUM and independent registries, whether they come from the UK or Australia are excellent.

I mean, in the med-tech business in my 20 years in this business, you can count on one hand the number of opportunities you have to talk about data that are that differentiated with OXINIUM And of course, different fields have different the role of data in terms of utilization. But having said that, we see really differentiated elements of our portfolio to drive continued growth that in the orthopedic side. So, I hope that answers your question, Chris.

Operator

Our next question comes from David Adlington from JP Morgan. David, please go ahead.

David Adlington

Morning guys and also iterate my apologies that you may have covered this off already, but just with respect to that 24 target 21% and coming back to sounds a note in terms of the margin bridge. 17% this year, you sound like you've got 40 to 50 basis points headwind from currency next year to the margin.

You obviously got some, probably some underlying inflation pressures next year as well, but put some offsets with respect to cost savings and probably less dilution from some of the acquisitions. So, I suppose the big question is, if you get to 18 - 18.5 next year, if we're kind of lucky that leads you with a 300 basis points, jump into ‘21. I've doing this '20 odd years and I can't think of a company that's done that sort of margin improvement in one year in immature company. So any sort of comfort you can give us around that, where that's from?

And secondly, so again, bigger pictured one for you, Deep, you came into the role beginning of this year. I think there's a messaging given that you sort of brought into those targets. I just wondered if you thought that they had become a bit of a millstone around your neck?

Deepak Nath

Well, David, look, there's no question that there is a bigger jump off point, whether you look at it from '22 to '23 or '23 into '24, it's equally -- we're facing, I would say relative to when the plans were put in place. The scale of headwinds, macro headwinds that we're getting into are significantly higher inflationary pressures being one of them continued pressure on supply chains from all sorts of factors, significantly higher than anything we could have anyone could have forecast in '20. So, back when the plan was put in place.

So there's no question that we're going this plan now is being executed on in a different macro environment that was envisioned. Having said this, I indicated when I first got here that I have embraced the strategy and embraced the set of targets as my own. And I meant what I said. What I've done over the last hundred days, or 90, some odd since the last time I was before you, is really dig into the business and understand how we're going to get there, right?

The path that we had thought about in December needed to be refined, needed to be rethought in order to go about achieving the target. That's been the focus of my work. I acknowledge the delta and the steps that you've taken, but what much of what we're doing are not incremental changes. In orthopedics, it's a fix, right? It was a conscious choice of words because it's not working as an orthopedics business should.

So it's not a linear kind of path from here to '24. The fixes that we're expect that we're putting in place, I expect to pay off in non-linear kind of ways once we get the wiring, right, get the commercial and operation teams working as they should, and put the processes in place that any orthopedics business should have. And we've got the people who know what goods looks like, who are kind of executing on these things. I expect to have non-linear jumps in terms of our performance in orthopedics that drives this.

The portfolio piece of it is key again we didn't have a full portfolio. We now have a full portfolio. We need to execute now with that full portfolio and the process that's in place. So I expect the benefits from that to accrue in a non-linear fashion. In sports and in wound, it's a different story. It's of course, building off of an already strong base. So there it's perhaps a bit more kind of I don't want to say forecastable, but perhaps you can draw more of a straight line from where we are to where we expect to be.

So there it's about really kind of changing the trajectory, but we already have at hand the things at work. So is it going to be easy? No. Am I going to be sleeping well at night, every night between now and 2024? I can honestly say that I'm going to be sweating this stuff every day. But do I feel that the actions we've outlined are the ones that get us there, absolutely.

So, I had the opportunity to come here and talk about a different picture, right? And I'm not doing that today. I'm talking about this year's and not about everything else. And that means that I've got the conviction that we can get there with the actions that we've outlined.

Operator

I think, we'll call a day there. Thank you very much.

Anne-Francoise Nesmes

Thank you.

Deepak Nath

Thank you very much.

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Smith & Nephew plc (SNN) CEO Deepak Nath on Q2 2022 Results - Earnings Call Transcript