Smith & Nephew looks limp

Unconfirmed media reports that medical devices manufacturer Smith & Nephew rejected a bid approach from US giant Johnson & Johnson before Christmas have sent its shares soaring in recent weeks. The trouble is, there's not a lot beyond bid rumour to keep the share price firm, and on other metrics the shares look far from attractive.

Last year was one of mixed trading, with only a partial recovery expected this year. That difficult backdrop reflects a legacy of poor acquisitions in recent years, combined with the near drying-up of hospital capital spending. And while there are signs that activity is returning to some areas of the medical devices market, the big uncertainty facing the group is whether sales growth will regain its past momentum in an age of hefty government budget deficits.

Reflecting that latter issue, major pricing pressures have already begun to emerge as governments around the world struggle to contain healthcare costs. In fact, analysts at investment bank Goldman Sachs reckon that the structurally high costs that accompany an ageing population will eventually mean a squeeze on prices for most medical devices. In practice, that would mean limiting doctors' historic autonomy over choosing devices for patients, with an ensuing standardisation of devices to keep costs down. It also appears to be a problem that the group's management recognises - November's third-quarter trading update made reference to potential cost savings in the business that could help balance product investment and tackle margin pressure.

Demand is struggling for other reasons, too. Orthopaedic implants remain the mainstay for Smith & Nephew with about 66 per cent of sales being generated by hips and knees. But the group also boasts a larger than average presence in the under-65s market - typically due to sporting type injuries - and that presents its own unique set of challenges. That's because this younger age group is especially reluctant to take time off from a difficult jobs market for elective surgery.

More share tips and updates...

What's more, investment in research & development (R&D) also looks badly needed after a number of recent safety scares. Indeed, the industry has generally been poor at updating its technology. In 2007, for instance, Smith & Nephew had to recall knee implants, while all devices companies have suffered by association after Johnson & Johnson's DePuy subsidiary had to recall metal-on-metal hip implants after some patients suffered side-effects from metal residue entering the blood stream. The group's manufacturing processes also came under the spotlight after the US Food & Drug Administration expressed concerns over quality control at one of the company's German manufacturing facilities.

Still, the company's operational performance is at least showing signs of improvement, with wound care sales having grown by an underlying 7 per cent in the third quarter to $230m (£147m). Even the orthopaedics business delivered sales growth of 3 per cent in the nine months to 2 October - ahead of the global average. And, with a relatively modest debt pile, the group's balance sheet looks healthy, too. Smith & Nephew is smaller than its main US rivals - such as Stryker, Zimmer and Johnson & Johnson - and its technology would fit nicely within several different device portfolios. Such factors certainly add credibility to the current bid chatter.

But while the emergence of bidder isn't inconceivable, shareholders need to be cautious - especially concerning a tie-up with Johnson & Johnson. Its DePuy unit, for example, boasts a 22 per cent global market share of the hip and knee joint reconstruction market, while Smith & Nephew's slice stand at around 12 per cent. Putting them together will inevitably cause problems for competition regulators. "Any deal involving the two companies would face significant regulatory hurdles, both in the US and in Europe, with particular attention drawn to the combined entity's share in specific markets such as Germany and the UK," points out analyst Jeremy Batstone-Carr of broker Charles Stanley.