This medtech stalwart is chronically overlooked

Marketed under the brand names Ozempic and Wegovy, the mass rollout of the weight-loss drug has sent jitters through some sectors. Snack food giants are bracing for the profit impact of reduced appetites, as are some supermarkets, including Walmart (US:WMT). If recent share price declines is any indication, investors in medical device companies also believe the obesity treatments will slash demand for joint replacement surgery. 

It has been a trying couple of quarters for firms with exposure to what’s known in industry jargon as the recon (meaning 'reconstructive') market. Major North American players Stryker (US:SYK) and Zimmer Biomet Holdings (US:ZBH) are down 13 per cent and 24 per cent, respectively, across the last six months. London-listed Smith & Nephew (SN.) is the worst off, with its shares falling some 28 per cent since late April. The reasons for these pessimistic sentiments are varied and not merely limited to the mass rollout of semaglutide products. The less-than-rosy macroeconomic picture has no doubt played a part as well.

However, Smith & Nephew has also been the focus of bearish attention because of its well-documented operational difficulties. Chief among these is a stagnant orthopaedics division, which has been ceding market share to competitors. Things have also been rocky on the management front, with the company now on its third CEO in four years. Current head Deepak Nath, who took up the post in April last year, wasted little time trying to reform the business. He introduced a 12-point plan for growth that July and has spoken candidly about his predecessors’ shortcomings. 

“Over the last couple of years, we have lost share not because we’ve necessarily been displaced from accounts but because we’ve given up procedures largely on the back of our failure to supply reliably,” he said on an earnings call in August. “To put it simply, there are surgeons that are already trained in our systems who have had to resort to other companies’ products because we haven’t been able to supply as well or as regularly as we should have.”

That’s quite the acknowledgement. Nath will hope it’s also a prescription for what Smith & Nephew must now do to rebuild the trust of both clients and investors.

Recently, the latter cohort’s focus has been on margins. Ahead of half-year results, consensus forecasts put trading profit margins – which strip out one-off costs –at 16.3 per cent. In the event, the reported margin was just 15.3 per cent, though management left its full-year guidance unchanged at 17.5 per cent, meaning second-half margins need to climb substantially. Some analysts feel this may be a stretch given the recent history of sub-standard delivery.

Broker UBS went as far as stating that margin guidance is “too high”, noting the “record levels of sequential margin expansion” required in the six months to December to hit the 2023 full-year target. Looking ahead, Smith & Nephew would need to deliver around 1.25 percentage points of margin expansion in the next two years to hit its 2025 target of 20 per cent. It has not managed more than 0.9 percentage points since 2010, noted UBS. 

The question now facing prospective investors is whether this failure is already priced into the shares, leaving the potential for a few positive surprises. There does tend to be a second half revenue bias in most years, though it’s not hugely significant, because people are more active in the summertime and therefore more prone to injuries. Patients in the US also tend to plan elective operations, such as knee replacements, towards the end of the year when their insurance deductibles are most likely to have been covered. So although Smith & Nephew’s full-year margin target looks like a stretch, it may not be a catastrophic miss, either.

The focus on ongoing profitability may have missed a potentially transformative reshuffle announced elsewhere in the group’s interim results. Smith & Nephew’s three divisions – orthopaedics, sports medicine and advanced wound management – were previously operated as franchises. Each was managed independently, although the Europe, the Middle East and Africa (EMEA) and Asia Pacific regions were hived off as separate units and were responsible for sales across all three franchises. 

The new structure is organised around three global business units, each with a chief operating decision maker who monitors performance and allocates resources. Analysts at Liberum, who described the previous set up as “disjointed and inefficient”, now see the potential for clearer reporting lines and better communications within the business. “Rather than having individuals accountable for things they can influence, the old structure ran the risk that the regional heads could claim they didn’t hit their targets because they didn’t get the products they needed from the franchise heads,” the broker explained in a recent note. 

Nath said he was trying to achieve greater accountability with the restructure – improving decision making, removing inefficiencies and “simplifying how we operate”. Bulls will say the group’s management has laid the groundwork for a re-rating, while bears might think additional guidance misses could drive the shares down further. A reverse discounted cash flow analysis by UBS suggested the market was pricing in mid-term annual revenue growth of 3.5-4.5 per cent and a margin of 20.5 per cent or under in early August.

Since then, the shares have declined a further 18 per cent, suggesting investors do not buy company guidance for annual revenue growth of 5 per cent and a margin of at least 20 per cent. Smith & Nephew now trades on just 12 times’ the consensus earnings forecast for the next 12 months, its lowest forward rating in more than a decade. Its closest London-listed comparator, ConvaTec (CTEC), trades on almost 17 times, by comparison.

Smith & Nephew is, in other words, very attractively priced. On a forward price-to-sales basis, the stock was only ever this cheap for a few months in 2008 and 2009. Given that it operates in a defensive sector, and management has taken steps to address organisational and operational inefficiencies, pessimism may have gone too far. On balance, it’s unlikely that demand for hip and knee replacements is about to drop off a cliff.

The whole weight-loss drug frenzy may even have obscured an opportunity. Some patients are poor candidates for joint replacement because they’re overweight, meaning weight-loss drugs could theoretically improve demand for S&N products. “Probably more important is the impact to the [total addressable market] from increasing the number of patients with a BMI within a range that permits them to have surgery,” notes RBC. A more active population may also incur more wear-and-tear on its joints, making hip and knee replacements far from obsolete. 

While the company’s own recovery process won’t be linear, market negativity has created a potentially compelling opportunity for investors.