At first glance, Smith & Nephew (SN.) is the type of business you’d be interested in owning a slice of. It makes things that solve problems and improve people’s lives that not too many other companies do. It is also very profitable. After a period of struggling to move forward, a new chief executive looks like he is moving the company in the right direction again. He has a reputation of being a dealmaker, which begs the question as to whether he will turn the company into a healthcare giant or end up selling it to someone else.
The business
Smith & Nephew is a global healthcare business specialising in making medical devices. Its business is concentrated on three main market areas:
- Orthopaedics – the biggest source of revenue. The company makes hip and knee replacement products, along with products to treat arthritis and traumas such as reconnecting bone deformities by screwing them back together.
- Sports medicine. Products here are used to repair soft tissue injuries as well as degenerative conditions of the shoulders, knees and hips.
- Advanced wound management. The focus is on treating wounds and protecting them from problems such as inflammation, infection and poor healing. Products include silver and iodine dressings, moisture absorption treatments, skincare gels and skin ulcer and burn treatments. The company is a leader in negative pressure wound therapy, which is an alternative to traditional wound dressings that speeds up recovery and lowers healthcare costs.
The split of the company’s revenue is shown in the pie chart below:
The company is undoubtedly exposed to attractive markets, underpinned by trends such as ageing populations, which will need more joint replacements, and the growing wealth of emerging Asian economies, which can increasingly afford better healthcare treatments.
But affordability works both ways. In developed western markets, government and insurance-funded healthcare systems are under pressure to save money. To succeed, companies such as Smith & Nephew have to make products that not only solve problems, but also save costs as well.
Arguably one of the most attractive characteristics of Smith & Nephew’s business from an investor’s point of view is that there are substantial barriers to entry, which limit competition. Regulation is high, with products having to be both safe and effective. Without authorisation from government healthcare agencies, you do not have a money-making product.
There is also significant pressure to innovate and develop new products. This leads to substantial research and development costs, which are difficult to support for small businesses. Last year, Smith & Nephew invested $246m (£193m) in research and development – equivalent to 5 per cent of revenues.
Despite attractive market fundamentals, Smith & Nephew has a very patchy record of revenue growth in recent years. Between 2014 and 2018, revenue growth has averaged a lacklustre 2.9 per cent a year. There have been pockets of success from the sports medicine and advanced wound management divisions, but in its core implants business it’s hard not to think that you are looking at a fairly uninspiring, low-growth business.
Smith & Nephew revenue trends 2014-18
$m | 2014 | 2015 | 2016 | 2017 | 2018 | 2018 growth rate | CAGR 2014-18 |
Sports Medicine & Joint Repair | 522 | 548 | 587 | 627 | 697 | 11.2% | 7.5% |
Arthroscopic Enabling Technologies | 596 | 631 | 631 | 615 | 600 | -2.4% | 0.2% |
Trauma & Extremities | 506 | 497 | 475 | 495 | 493 | -0.4% | -0.6% |
Other Surgical Business | 147 | 205 | 214 | 189 | 209 | 10.6% | 9.2% |
Knee Implants | 873 | 883 | 932 | 984 | 1017 | 3.4% | 3.9% |
Hip Implants | 654 | 604 | 597 | 599 | 613 | 2.3% | -1.6% |
Advanced Wound Care | 805 | 755 | 719 | 720 | 740 | 2.8% | -2.1% |
Advanced Wound Bioactives | 322 | 344 | 342 | 342 | 320 | -6.4% | -0.2% |
Advanced Wound Devices | 192 | 167 | 172 | 194 | 215 | 10.8% | 2.9% |
Total | 4,617 | 4,634 | 4,669 | 4,765 | 4,904 | 2.9% | 1.5% |
Source: Annual reports
As well as growth, the other key concern regarding Smith & Nephew is that, with the exception of sports medicine, it is not big enough – it doesn’t have a big enough slice of the markets it is competing in.
This is where the influence of newish chief executive Namal Nawana is likely to be significant in the coming years. He came from US diagnostics company Alere and had a reputation for splashing the cash before selling the business in 2016. He looks set to do the same thing with Smith & Nephew.
This year, the company has been busy buying up companies specialising in meniscal repair, pressure injuries, joint reconstruction and optical tracking cameras. Its biggest deal has been the $660m purchase of Osiris, which makes products that repair skin, bone and cartilage. The company was also linked with a potential $3bn-plus acquisition of Nasdaq-listed spinal specialist Nuvasive.
The chief executive has been very open about the fact that Smith & Nephew hasn’t done enough buying in recent years and that its balance sheet is relatively lightly geared – net debt was just 1.0 times operating cash flow last year – and can support much more debt, especially if it comes with a quality and growing income stream.
This brings with it the risks of overpaying in the pursuit of getting bigger. The real test of the chief executive and his team will be in getting levels of organic growth to increase. The internal culture of the company has been shaken up, with lots of extra resources channelled into business development.
The initial results are quite encouraging. The first quarter of 2019 saw underlying revenue growth of 4.4 per cent, with the company comfortable enough to state that it should be capable of delivering growth of around 3.5 per cent for the year as a whole with some operating margin improvements on top.
This is okay, but is by no means anything to get excited about, in my opinion, but a little bit more acceleration in the growth rate at a margin of 23 per cent definitely gives fuel to the bulls of the shares who think that Smith & Nephew’s valuation might be on the cheap side relative to its peers.
Financial performance
Even with sluggish revenue growth, Smith & Nephew has maintained high levels of profitability as evidenced by its profit margins and return on capital employed (ROCE).
S&N $m | 2014 | 2015 | 2016 | 2017 | 2018 |
Revenue | 4,617 | 4,634 | 4,669 | 4,765 | 4,904 |
Operating profit | 1,055 | 1,099 | 1,020 | 1,048 | 1,123 |
Post-tax profit | 743 | 761 | 735 | 826 | 881 |
Capital employed | 6,183 | 5,869 | 6,082 | 6,547 | 6,758 |
Capex | 375 | 358 | 392 | 376 | 347 |
Operating cash flow | 961 | 1,203 | 1,035 | 1,273 | 1,108 |
Free cash flow (FCF) | 308 | 672 | 457 | 714 | 586 |
Net debt | 1,613 | 1,361 | 1,550 | 1,281 | 1,104 |
Ratios: | |||||
Operating margin | 22.9% | 23.7% | 21.8% | 22.0% | 22.9% |
ROCE | 17.1% | 18.7% | 16.8% | 16.0% | 16.6% |
Operating cash conversion | 91.1% | 109.5% | 101.5% | 121.5% | 98.7% |
FCF conversion | 41.5% | 88.3% | 62.2% | 86.4% | 66.5% |
Capex ratio | 8.1% | 7.7% | 8.4% | 7.9% | 7.1% |
FCF margin | 6.7% | 14.5% | 9.8% | 15.0% | 11.9% |
Net debt/operating cash flow | 1.7 | 1.1 | 1.5 | 1.0 | 1.0 |
Source: Annual reports/Investors Chronicle
But another job Mr Nawana and his finance director might want to turn their attention to – as well as buying companies – is improving the company’s cash generation, which doesn’t look great to me. The conversion of operating profits into operating cash flow could be better – it's not disastrous – but the business does consume a significant amount of working capital.
Stock levels as a percentage of sales are high and have been going higher, which is not something you want to see. Receivables are also on a rising trend.
The company explains the stock build as a result of new products and sales growth, whereas receivables are explained by collection timing periods. A look at Stryker, a competitor, suggests that cash conversion and working capital may be an industry issue and can cause substantial volatility in free cash flows.
Stryker $m | 2014 | 2015 | 2016 | 2017 | 2018 |
Revenue | 9,675 | 9,946 | 11,325 | 12,444 | 13,601 |
Operating profit | 1,255 | 1,872 | 2,175 | 2,297 | 2,537 |
Post-tax profit | 515 | 1,439 | 1,647 | 1,020 | 3,553 |
Capital employed | 13,545 | 13,489 | 17,515 | 19,344 | 23,795 |
Capex | 233 | 270 | 490 | 598 | 572 |
Operating cash flow | 2,321 | 1,497 | 2,948 | 2,102 | 3,397 |
Free cash flow (FCF) | 1,549 | 629 | 1,322 | 961 | 2,038 |
Net debt | -1,048 | -81 | 3,530 | 4,429 | 6,160 |
Ratios: | |||||
Operating margin | 13.0% | 18.8% | 19.2% | 18.5% | 18.7% |
ROCE | 9.3% | 13.9% | 12.4% | 11.9% | 10.7% |
Operating cash conversion | 184.9% | 80.0% | 135.5% | 91.5% | 133.9% |
FCF conversion | 300.8% | 43.7% | 80.3% | 94.2% | 57.4% |
Capex ratio | 2.4% | 2.7% | 4.3% | 4.8% | 4.2% |
FCF margin | 16.0% | 6.3% | 11.7% | 7.7% | 15.0% |
Net debt/operating cash flow | -0.5 | -0.1 | 1.2 | 2.1 | 1.8 |
Source: Annual reports/Investors Chronicle
Both Stryker and Smith & Nephew have produced free cash flow margins of 15 per cent during the past two years. If Smith & Nephew could do that consistently then I think that would be a very positive development. To do so, it would have to change the internal workings of its business. Stock control can be improved, but getting national health services and insurance companies to pay you faster is probably going to be more difficult.
Forecasts and valuation
Year ($m) | 2019 | 2020 | 2021 |
Turnover | 5,075.70 | 5,269.50 | 5,474.20 |
Ebitda | 1,494.50 | 1,592.90 | 1,677.00 |
Ebit | 1,149.10 | 1,233.40 | 1,311.50 |
Pre-tax profit | 1,041.60 | 1,107.00 | 1,178.10 |
Post-tax profit | 865.7 | 928.6 | 991.3 |
EPS (¢) | 101 | 108.1 | 116.6 |
Dividend (p) | 29.4 | 33.2 | 33.8 |
Capex | 408.6 | 407.2 | 421.7 |
Free cash flow | 699.3 | 820.1 | 906 |
Net borrowing | 1,158.50 | 1,033.20 | 236.1 |
Source: SharePad
Smith & Nephew shares have been on a storming run and are up by over 30 per cent over the past year. Current analysts’ forecasts do not look overly challenging, which makes the shares look quite interesting on a one-year forecast rolling price/earnings (PE) ratio of 20.8 times at a share price of 1,730p. This compares with Stryker and Nuvasive on around 24 times.
A potential reliance on acquisitions and inconsistent free cash generation don’t rest easy with me, but I can’t help thinking that there is a very decent business in Smith & Nephew waiting to be unleashed and that could end up performing a lot better in a few years’ time. If done at the right price, acquisitions have the potential to enhance the breadth, quality and growth prospects of the business.
The company has long been touted as a takeover target and if that scenario comes to pass then it is likely to do so at a much higher share price than its shares are currently trading at.
