Shrinking margins spook Smith & Nephew investors

On the face of it, medical device maker Smith & Nephew (SN) had a respectable first half of the year, with both revenue and pre-tax profit growing by single-digit percentages. But investors seem to think there’s trouble brewing under the surface for the FTSE 100 constituent, as its shares fell by over 3 per cent on the morning of its results announcement. 

The problem, according to analysts at UBS, is the lower-than-anticipated trading profit margin of 15.3 per cent. This figure “raises doubts on 2023 full-year margins and the 2025 targets”, they warned in a 3 August note. After a period of chronic underperformance, management introduced a 12-point plan to transform the business last July. 

One of the scheme’s key objectives is to overhaul the group’s all-important Orthopaedics business, which has lost market share in recent years. The division did, however, achieve revenue growth of 4.6 per cent on a reported basis across the six months to the end of June, reflecting a higher volume of elective procedures and growth in the robotics segment.

Smith & Nephew’s two other divisions – Sports Medicine & ENT and Advanced Wound Management – also reported sales growth of 10.4 per cent and 5.5 per cent, respectively. Management has subsequently raised its full-year revenue guidance to 6-7 per cent (from 5-6 per cent previously). 

The issues facing the group only really become evident when you study its earnings numbers. Trading profit – a measure of group profitability that excludes the impact of exceptional or one-off transactions – fell 5 per cent year on year to $417mn (£328mn). This is 6 per cent lower than City analysts had predicted. 

UBS noted that the group’s first-half trading profit margin was its worst in a decade, excluding pandemic-hit 2020. “Furthermore, we believe 2023 is benefiting from a one-off backlog recovery in elective procedures, which appears to be normalising based on recent commentary/guidance,” they added. 

FactSet broker consensus puts the group’s full-year price/earning multiple at just over 17 times, making it significantly cheaper than its closest UK competitor, Convatec (CTEC), on 22 times. However, we don’t think this constitutes an argument for buying the shares, which could continue falling if margin guidance is missed in the coming quarters. 

At the same time, we don’t think the group’s turnaround is a lost cause, but caution is warranted until its trajectory becomes clearer. Hold.

Last IC View: Hold, 1,203p, 21 February 2023