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A foolish notion

“Don’t worry,” said the eager surgeon before he got to work with his rusty scalpel, “we’ll have you back on a tennis court in eight weeks maximum”. Perhaps he simply forgot to add that I’d be limping onto the court, supported by a crutch, only to say hello to erstwhile opponents. Anyway, 10 months later I was just about able to start the journey back to match fitness.

My surgeon might have done a better job with access to smart technology, such as the so-called NovoStitch Pro meniscus repair kit that Smith & Nephew (SN.) is about to add to its sports medicine line-up via the $50m (£40m) acquisition of Ceterix Orthopaedics, a California-based knee-repair specialist.

Fill-in deals such as these – useful in their own right – also offer PR opportunities for companies with a newish chief. On cue, the new boss will recite clichés about ‘seeking opportunities’, ‘fulfilling potential’ while respecting the corporate culture of the great organisation he or she is privileged to lead. In Smith & Nephew’s case, that task falls to 48-year-old Namal Nawana, who has now had a few months to familiarise himself with the task.

Such marketing may be obligatory for a new chief; whether it’s convincing is another matter. I recall Mr Nawana’s predecessor, Olivier Bohuon, saying much the same, as did his predecessor, David Illingworth, and so on all the way back to the 1980s.

It’s not that Smith & Nephew is a corporate failure – far from it – but it has never consistently lived up to expectations or to the rating at which its shares have traded or, indeed, currently trade – 19 times likely earnings for the year just ended with the price at 1,412p. For a group that makes 95 per cent of its sales outside the UK, a premium rating to the FTSE 100’s average might be justified. But Smith’s rating compares with 11 times for the Footsie, which is a real stretch given its performance ratios and growth rates shown in the tables.

Table 1: Some basic numbers
 Share price*Mkt cap ($m)Revenue ($m)Profit margin (%)Return on assets (%)Return on equity (%)
Smith & Nephew1,412p15,8364,86917.37.016.2
Stryker$15758,74713,27621.58.212.2
Zimmer Biomet$10421,1937,95119.83.815.5
ColoplastDKK60919,8732,51131.327.062.2
*In local currency. Source: S&P Capital IQ

Of the four leading companies in Smith & Nephew’s segments of the healthcare market – basically, orthopaedics and wound management – the UK-based company is clearly the laggard. Only on metrics for return on assets, return on equity and dividend growth rate does it edge ahead of Zimmer Biomet (US:ZBH). On all other measures it trails fourth out of four.

Table 2: Compound growth on 5 years (% pa)
 RevenueOp'g profitEPS Op'g cashDividends
Smith & Nephew3.1-1.36.44.06.7
Stryker8.416.36.84.412.1
Zimmer Biomet11.84.116.811.44.2
Coloplast7.27.07.56.89.5
Source: S&P Capital IQ

Paradoxically, that may partly explain the high rating because Smith is so often rumoured to be a takeover target; to the extent that in 2014 the industry leader, Stryker (US:SYK), had to go on the record to spell out that it had no intention to bid. Such rumours may well justify keeping Smith’s shares for investors who already have them. But what about buying them?

Almost needless to say, the shares don’t come out well in the Bearbull valuation spreadsheets. That’s because the required rates of return that drive my estimates of value – either implicitly or explicitly – are far higher than the required rates implicit in a PE ratio of 19 times.

Nor does Smith & Nephew shine in those value drivers that focus solely on a company’s internal performance. For example, its productivity – as measured by gross profit per employee, which often correlates well with share-price performance – declined in the five years to 2017. Most likely that was the effect of 2014’s $1.7bn acquisition of ArthroCare. As a result, profit per employee, which was $307,000 in 2012, had dropped to $221,000 in 2017. Similarly, in its conversion of accounting profits into cash, Smith does not pull up trees, even though capital spending usually comes in just under the amount charged for depreciation and amortisation.

Small wonder, then, that activist investor Elliott Management lobbied for a break-up last year. Alternatively, investors might demand higher dividends, which, if nothing else, would remove management’s comfort blanket; usually, the company pays out less than half its free cash flow on dividends.

So it is possible to see why, despite various shortcomings, Smith’s shares have performed well these past five years and may continue to do so – a mix of acceptable returns on capital, serving growth markets, cash generation that could afford higher dividends and takeover/break-up potential. True, there would be an element of ‘greater fool theory’ in buying the shares at these levels. But life tells us that greater fools do eventually pitch up.