Buy under-rated Smith & Nephew

Medical devices are in growing demand in developed and developing nations due to the impact of ageing populations and 'diseases of affluence', such as obesity. Smith & Nephew has aligned its portfolio to reflect this. In 2016, it sold its struggling gynaecology business to focus on three franchises: sports medicine and trauma, joint reconstruction and advanced wound management. The majority of revenues are generated in the US and other wealthy countries, but the group also has a growing presence in emerging markets, where revenues grew 14 per cent on an underlying basis in 2017.  

Management may have been criticised for a long period of investment, but we think this strategy has been very sensible as competition picks up in the global medical devices arena. In sports medicine and trauma, the group’s products are now world leaders, while its new knee joint device has helped boost revenues in its reconstruction business above that of US giant Stryker. Together, the sports medicine and reconstruction divisions are expected to generate annual sales of $4bn (£2.9bn) by 2020, up from $3.5bn last year.

Meanwhile, plans are in place to cut costs. Under its accelerating performance and execution (Apex) strategy, the group is set to reduce its manufacturing base and supply chain costs, increase sales and marketing effectiveness, and update old IT systems. This is expected to save roughly $160m a year by 2022, with around three-quarters due by 2020 – although the strategy will come with an upfront cost of $240m, $100m of which is expected this year. JPMorgan therefore expects a slight dent in pre-tax profits in the 2018 financial year, before numbers accelerate the year after that. The broker forecasts compound annual earnings growth of 6 per cent between 2017 and 2020.

That is why we think the group’s enterprise value (EV) to 2018 adjusted cash profits (EV/Ebitda) ratio of 10.5 times looks unjustified, particularly compared with the valuations of its struggling British peer ConvaTec (CTEC) – 13 times EV/Ebitda – or the significantly smaller Advanced Medical Solutions (AMS)  on 21 times. Recent takeovers also indicate the value in Smith & Nephew shares: US giant Johnson & Johnson paid 17 times operating profits for Synthes in 2012 and Biomet was lossmaking when Zimmer bought it for $14bn in 2014.  

Smith & Nephew’s recent share price weakness can be partly blamed on the very public criticism made by activist investor Elliott, which is rumoured to have taken a position in the company in late 2017. The fund has been pressuring Smith & Nephew to trim down its portfolio so that it is more attractive as a takeover target, but management has insisted that the group is an acquirer and not a target. In late October, it acquired shoulder repair specialist Rotation Medical for a potential total payment of $210m. The new company – which owns highly innovative shoulder surgery technology – will “accelerate the transformation of Smith & Nephew to higher growth”, according to the outgoing chief executive, Olivier Bohuon.

Further acquisitions could be a catalyst for a recovery in the share price. The group has around £2bn available for acquisitions or share buybacks, given its relatively light debt burden and ability to generate cash. At the end of 2017, net debt had fallen to 1.4 times adjusted cash profits, thanks largely to $1.27bn of operating cash flow, up from $1.04bn in the prior year. JP Morgan expects operating cash inflows to rise to $1.5bn by 2019.