The past few months have been eventful for replacement hip and knee specialist Smith & Nephew, as its new bosses plunge into the acquisitions market to help diversify group revenues. The aim is to reduce Smith & Nephew's reliance on global demand for medical devices by boosting the woundcare side of the group. City analysts agree that the logic is sound. The trouble is that the plan carries risks that could undermine the share price. Assuming that the share price follows its familiar pattern early in the year, the shares are a trading sell.
- Share buybacks still possible
- Healthy profit margins
- Pressure on healthcare budgets
- Expansion into woundcare is speculative
- Capital returns not compatible with diversification
- Share price tends to give up early-year gains
Smith & Nephew's results for 2012 were clear about the state of the market for replacement joints in Europe and North America. Revenues showed some underlying growth - up 2 per cent to $4.13bn - and profits were boosted by cost savings, rising 6 per cent to $965m (£618.80m). However, the market is still tough and analysts expect only slow growth in the first three quarters of 2013. True, new products have been launched, but it will take some time for them to translate into faster sales growth.
And all the while Smith & Nephew must grapple with the increasing strain on healthcare budgets in the developed world. This means that, although ageing populations generate higher demand for its hips and knees, the public purse and healthcare insurers struggle to meet the costs of treatment. It is difficult to see how this situation will improve much, so Smith & Nephew must continue to rely on cost savings to underpin its healthy profit margins. But it is doubtful that continual cost savings can translate into a successful long-term plan.
To offset this problem, acquisitions are likely to play a greater role, with the buyout of US company Healthpoint looking an adventurous move. Its acquisition in November for $782m (£488m) surprised many observers both by its timing and by the fact that Smith & Nephew paid more than 70 times Healthpoint's cash profits. The company specialises in treating difficult-to-heal wounds by developing medical products that remove dead tissue. One product, Santyl, accounts for 75 per cent of Healthpoint's sales. However, the real promise in Healthpoint is its experimental treatment for venous leg ulcers, HP802-247, which is in late-stage clinical trials.
SMITH & NEPHEW | ||||
|---|---|---|---|---|
| ORD PRICE: | 706p | MARKET VALUE: | £6.39bn | |
| TOUCH: | 706-707p | 12M HIGH: | 738p | LOW: 567p |
| DIVIDEND YIELD: | 2.7% | PE RATIO: | 13 | |
| NET ASSET VALUE: | 256p | NET DEBT: | 7% | |
| Year to 31 Dec | Turnover ($bn) | Pre-tax profit ($bn) | Earnings per share (¢) | Dividend per share (¢) |
|---|---|---|---|---|
| 2010 | 3.96 | 0.67 | 69.3 | 15.8 |
| 2011 | 4.27 | 0.85 | 65.3 | 17.4 |
| 2012 | 4.14 | 1.10 | 81.3 | 26.1 |
| 2013* | 4.39 | 0.88 | 78.9 | 27.4 |
| 2014* | 4.60 | 1.02 | 86.3 | 30.0 |
| % change | +5 | +16 | +9 | +9 |
Normal market size: 4,000 Matched bargain trading Beta: 0.8 *Investec forecasts £1=$1.57 | ||||
While HP802-247 is an opportunity to boost medium-term sales, the risks are also high, if precedent is a guide. Pharmaceuticals specialist Shire failed last year with Dermagraft in venous leg ulcers - Dermagraft had once belonged to Smith & Nephew - and its share price suffered accordingly. Treating the condition with compression bandages is successful in 70 per cent of cases and HP802-247 will need to show a higher success rate in a shorter length of time to convince payers to fund its use. Santyl is a successful product and its sales have grown over the past few years, primarily after the US drugs regulator withdrew the marketing licence for its principal competing product. However, that situation could change should another competitor come along. In short, given the price paid, Healthpoint is not a sure-fire winner, yet Smith & Nephew's share price has risen over 8 per cent since the deal was announced.
Then there is a longstanding debate about whether Smith & Nephew will gear up its balance sheet (net debt is just 7 per cent of shareholders' funds) to boost shareholders' returns by buying in shares. Some analysts think it could afford to buy in 20 per cent of its equity, but there was no sign of such a move at the last results. Besides, analysts at investment bank JPMorgan think Smith & Nephew has a choice between expansion and diversification and handing back cash to shareholders, but it cannot do both decisively and this could become a source of discontent.
