SNNUF - Smith & Nephew: Progress But More Work Ahead In Ortho

Summary

• Smith & Nephew plc's fourth quarter results were mixed; Ortho is still lagging its rivals, but Sports Medicine & ENT and Advanced Wound Care outperformed.
• The company has the technology to be more competitive in ortho and gain share in major joints and extremities, but whether management can execute on the necessary steps remains unknown.
• Mid-single-digit revenue growth and margin improvements can support a fair value in the mid-$30s, but ortho execution is an important driver for long-term re-rating.

Wall Street isn’t often the most patient place, but I have found that investors do tend to like credible turnaround stories when sectors get pricey. Smith & Nephew plc ( SNN ) management certainly has more work to do getting this business turned around, particularly in the orthopedics business, but fourth quarter performance was okay and guidance out to 2025 seems realistic, particularly if the company can deliver on improved sales execution for otherwise competitive products.

These shares have risen about 5% since my last update , modestly outperforming the broader med-tech space, as well as more direct rivals like Stryker Corporation ( SYK ) and Zimmer Biomet Holdings, Inc. ( ZBH ). I do find the valuation increasingly interesting in an otherwise often expensive med-tech market. While I have ongoing concerns about management’s ability to close the gap in major joints (an area that draws a lot of Street attention), I do like the performance in the other segments. I’m increasingly positive on the idea of taking a chance and buying into this self-improvement story ahead of more concrete evidence of success.

Mixed Results To Close The Year, Including Mixed Ortho Results

I found Smith & Nephew’s fourth quarter results to be frustrating in some respects. Overall revenue growth was okay, but ortho once again was a little softer than expected, while the Sports Medicine & ENT and Advanced Wound Management businesses were better.

Revenue rose almost 7% in overall organic terms, a small miss versus sell-side expectations, and somewhat lackluster next to the double-digit growth at Stryker and Zimmer for the same quarter. Ortho revenue rose about 4% as reported, a modest miss, with 5% growth in hips (7% excluding the impact of China’s value-based pricing (or VBP mechanism), 5.5% growth in knees (up almost 7% ex-VBP), and less than 1% growth in trauma and extremities. I found the latter most disappointing relative to peer reports.

The Sports Medicine & ENT business grew over 9%, beating expectations, with over 11% growth in sports medicine, 4% growth in arthroscopy and 17% growth in ENT. The Advanced Wound Management business grew 8%, also beating expectations, with 8% growth in wound care, 15% growth in wound devices, and 4% growth in bioactives.

Smith & Nephew doesn’t report quarterly financials beyond the revenue lines, making peer-to-peer margin comparisons more difficult. EBITA for the second half of the year fell 3% on a 6% organic revenue improvement, missing by about 1%, with margin down 70bp to 17.6%. Supply chain pressures continue to impact the business, not only in terms of input costs, but also supply constraints on important products (including major joint and extremity/trauma products).

Smith & Nephew Is Still Lagging In Ortho

Smith & Nephew’s performance in major joints was a microcosm of some of the frustrations I have about the progress with this business. While there was some evidence of improvement, the business still came up short and still has a ways to go before seriously challenging the major players for more market share.

Excluding the VBP impact, the hip business grew 7% worldwide, which was about two points better than Johnson & Johnson ( JNJ ), but more than three points behind Zimmer and more than five points behind Stryker. The U.S. hip business was even less competitive, with 5.5% growth that trailed Zimmer by more than two points, JNJ by almost four points, and Stryker by almost six points.

The global knee business grew close to 7% adjusted for VBP, but still modestly lagged JNJ, while lagging Stryker by about two and a half points and Zimmer by more than five points. The U.S. knee business grew almost 7%, lagging Stryker by half a point, JNJ by about four and a half points, and Zimmer by almost six points.

The trauma and extremities business was likewise subpar relative to its peers, though EVOS did help drive a return to growth.

Product availability can explain some of the challenges, with the supply of Polarstem hips and EVOS Small implants getting back to targeted levels during the fourth quarter, while the Journey II knee is still about 20% away from the target. A bigger issue remains sales execution – Smith & Nephew has some good products, including a cementless knee implant and a kinematic knee (kinematic knees are meant to more closely reproduce natural knee movement and have been popular with younger patients), but the company has struggled to get surgeons to give them a chance, and the business continues to suffer from margin pressures caused by the need to have a full-sized major joint operation without corresponding share.

I know management is bullish on the Cori robot, with five additional FDA approvals in 2022 and more on the way, but I’m more skeptical. I don’t think the Cori is good enough to take business away from Stryker’s Mako platform, nor Zimmer’s Rosa, and at best I think it’s a way of holding share in markets like ambulatory surgical centers and maybe fending off rivals like Enovis Corporation ( ENOV ) that don’t have similar offerings.

To be fair, these are still the early stages of what management has described as a two-year improvement plan. This plan includes improvements in production and delivery, a streamlined portfolio, and technology-driven share gains. I think the efforts to improve demand forecasting, asset utilization, and logistics should be easily attainable. Portfolio streamlining is understandable, but carries some risk (the risk of alienating surgeons who like the discontinued products). As far as leveraging technology to drive share, I’m bullish in certain products (cementless knee, kinematic knee, EVOS in trauma), but less confident in areas like robotics and extremities.

The Outlook

I was impressed with Smith & Nephew’s performance in Sports Med & ENT, and I believe this can continue to be a strong grower in areas like shoulder and knee repair, and I still believe the Tula ear tube system is a needle-mover for the company. Wound care is doing better than I expected, and I think the device side of the business can benefit from iffier execution at 3M Company ( MMM ).

Management’s initial targets for 2025 seem realistic to me. Management is assuming continued inflation, but not positive pricing, and only in-line growth for the ortho business (which, relatively speaking, is actually a bullish assumption in some respects). The company is also targeting about $200M in cost savings, with half coming from COGS and 40% from the sales and marketing efforts.

I really want to see improved sales execution in Ortho. The company is doing well with its other two core segments, but Ortho continues to be challenged by a range of issues including product availability and sales execution. I do believe that the technological capabilities of Smith & Nephew’s ortho portfolio merit more market share, but whether the company can drive the necessary market share shifts remains to be seen.

I don’t believe my expectations for Smith & Nephew are all that bullish or optimistic. I’m looking for long-term revenue growth of around 4.5%, which is above the 3.5% I expect from Zimmer, but Smith & Nephew has leverage to sports medicine and ENT businesses that should sustain a higher growth rate. I’m also assuming some improvement in major joints and extremities – I’m skeptical that the company can fully close the gap in major joints and extremities, but I think they can at least do better.

Smith & Nephew once generated 30% EBITDA margins, but I’m only expecting improvement from around 25% in FY’22 to 26% in FY’24, 27% in FY’25, and 28% in FY’27. The opportunity to do better than this is there, but I need a little more evidence before boosting my estimates. The mid-teens free cash flow ("FCF") margins that flow from this aren’t exceptional relative to peers, but do at least represent real improvement over a long-term average FCF margin closer to 10%, and can drive high single-digit adjusted FCF growth.

The Bottom Line

Between discounted cash flow and growth/margin-driven EV/revenue, I do believe that Smith & Nephew is likely undervalued today – discounted FCF supports a near-term fair value in the low-to-mid-$30’s, while margins and revenue growth support a fair value in the mid-$30’s to $40.

That’s a pretty good potential return, and I’m not assuming that the turnaround/self-improvement plan is a complete roaring success. That said, as much as the Street may like the relative value offered by turnarounds, they will also turn on these companies if they come up short. I think the risk-reward for Smith & Nephew plc stock here is getting more and more interesting and I’m tempted to call this a “buy” already, but I do still see lagging ortho performance as a key risk.

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