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Long a laggard in the ortho space, I was more bullish on Smith & Nephew (NYSE:SNN) last September on what I thought were cogent plans from a relatively new management to address and reverse this long-term pattern of underperformance. While a year and change may not be giving them enough time, particularly given the disruptions created by the pandemic, the reality is that the company hasn’t made the expected progress and isn’t getting the job done in either revenue growth or margin improvement.
With that ongoing disappointing run of performance, the share price has suffered, falling another 25% or so since my last update and underperforming peers/rivals including Stryker (SYK) and Zimmer Biomet (ZBH), but managing to outperform Enovis (ENOV). While the shares do look undervalued even without significant near-term improvement, I think it’s hard to make an argument for owning them without more evidence of real traction with the self-improvement initiatives.
Ongoing Ortho Share Erosion Is A Real Issue
One of the biggest concerns I have with Smith & Nephew is the ongoing poor performance of the major joint (hip and knee) business. It has been years since the company outperformed the market in combined hip and knee sales and only once in the last three years has the company outperformed in combined U.S. hips and knees.
On the positive side, the knee business has been doing better of late. The business grew more than 7% overall in the third quarter, beating expectations by about 1% and only modestly lagging the broader global knee market (though lagging Stryker’s 13%-plus growth), while the U.S. knee business grew a more modest 4% and lagged the market by more than five points (including nearly 14% growth at Stryker and 10% growth at Johnson & Johnson (JNJ).
The news with hips is even worse, with a 1% decline and 4% miss in the third quarter. The global and U.S. hip business has been a better performer in the past, but has been decelerating lately with almost 900bp (worldwide) and about 400bp (U.S.) of underperformance in Q3 after 900bp and 550bp of underperformance in Q2.
Smith & Nephew’s exposure to China and value-based pricing actions can explain some of this, and indeed the ortho business was up 5.6% excluding China (up 2.1% as reported overall). Still, weak pricing in China doesn’t explain the ongoing challenges in the U.S. where the company has been losing share. This share loss also comes despite the ongoing expansion of the CORI robotic system (now at over 500 installations, about 20% smaller than Zimmer’s Rosa base and about a third of Stryker’s MAKO base) and new introductions like the Legion Conceloc cementless knee.
Management isn’t ignoring the problem, and five points out of the company’s 12-point improvement plan address the ortho space, including efforts to rebuild the demand planning process, expand the adoption and use of CORI, and improve their marketing focus on key brands.
Even so, I’m losing confidence that management can really stem these losses, as Stryker appears to be on another level of performance now and Johnson & Johnson and Zimmer are both getting more serious about growth in major joints. I don’t see enough product innovation in major joints to get excited about, and I’d also note that Stryker and Zimmer have been stepping up their game with ambulatory surgery centers (or ASCs), an area of the market where Smith & Nephew has traditionally been stronger.
Productivity Remains An Issue, But It May Well Be More Structural Than Management Realizes
Another five points of the improvement plan address productivity, including improving the order process, streamlining procurement, and optimizing manufacturing. These are important targets, as Smith & Nephew lags Stryker and Zimmer in terms of core profitability, but I’m not sure manufacturing and sourcing are really the biggest issues, as Smith & Nephew’s gross margins aren’t all that bad.
I would, instead, like to see more emphasis on sales productivity and also on the long-term margin/return potential of the businesses/markets in which the company operates. Lack of scale certainly hurts the ortho business, as the company has to have the sales infrastructure of a major joint recon company, but doesn’t currently have the market share to leverage that infrastructure. Management isn’t going to abandon this segment, so it is even more important that efforts to innovate and effectively market those innovations gain traction.
As I’ve mentioned before, the wound care business is not all that attractive to me overall, and here too I wonder if the company is frittering away resources and margins in unproductive areas. Given significant price and reimbursement pressures (and this is an ongoing issue), I think this business needs to be run with a much more jaded eye towards maximizing profitability, as it will never really be a growth engine.
The Outlook
I’ve cut back my revenue expectations, as the company has not only been hit by challenges like value-based pricing, but also weaker performance in major joints. Sports medicine appears to be picking up and I still see potential in niches like the Tula ear tube product (which can be performed under local anesthesia in a doctor’s office), but the ongoing weakness in major joints is a major issue for me.
I’m now looking for long-term revenue growth of around 3% to 4%, below management’s 4%-6% target range. Is the potential to do better there? Perhaps, but I don’t have the same level of confidence in management’s ability to execute to that potential. At a minimum, there’s now more pressure to execute on newer growth opportunities like trauma (the EVOS platform) and extremities (a new shoulder implant).
Margin performance has likewise been lackluster, and I think management’s 21% adjusted operating margin target is simply too optimistic. Simply exceeding 19% in 2024 may be an accomplishment in its own right, and I’ve reduced my operating margin, EBITDA margin, and free cash flow margin assumptions. Some of this can be tied to sector-wide input cost challenges that should ease in the coming years, but underperformance on the top line, particularly in major joints, is also robbing the company of some of the margin leverage I’d previously modeled.
I’m still expecting Smith & Nephew to get to a 15% FCF margin over the next five years, which compared to a trailing average FCF margin of 12% is not a trivial important. Long term, I’m expecting gradual improvement into the high-teens versus prior projections toward 20%. The latter could still be possible if management can really execute on its self-improvement initiatives, but I regard that as a “show me” story now.
I value med-techs like Smith & Nephew through discounted free cash flow and margin/growth-driven EV/revenue. On the former, adjusted long-term core FCF growth of around 5% can support a high single-digit annualized return from here, and that’s not bad for a larger med-tech. Despite the company’s weaker margins, I believe a 3.25x forward revenue multiple is still appropriate, and that supports a fair value in the mid-$30s.
The Bottom Line
Not only is the Street not giving the stock credit for management’s growth and productivity initiatives, it’s not really even giving credit for the current level of profitability and growth. I admit that I find that tempting, and I think you can argue that the weak performance of the stock has derisked a lot of the self-improvement story.
I’m tempted to stay more bullish on this name as a value/turnaround play, but I want to see more evidence of an actual turnaround. If the company can gain ground in major joints, deliver good growth in sports medicine and show some margin improvement, this will be a name to consider again.
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