Smith & Nephew PLC (LON: SN.) – Sustainable business model with a robust balance sheet position

Smith & Nephew PLC is a FTSE 100 listed medical technology company with global operations. The Group was established in 1856 in Hull, United Kingdom. Currently, it operates in over 100 countries with more than 17,500 employees across its three global franchises, namely Advanced Wound Management, Orthopaedics and Sports Medicine & ENT (Ear, Nose and Throat) and generates US$5.1 billion in annual sales in 2019. The Group is focussed on five strategic priorities – expanding the established markets, continuous innovation, accelerating growth in emerging markets, supporting organic growth with acquisitions and improving the operating model. It became a constituent of LSE (London Stock Exchange) on 13th August 1951. On 18 February 2021, the Company will announce the Q4 FY20 and 2020 full-year results.

(Source: Presentation, Company Website)

Growth Prospects and Risk Assessment

The recently completed acquisition of Extremity Orthopaedics business of Integra Life Sciences Holdings Corporation for $240 million, will expand the portfolio in higher-growth extremities segment. The recent funding through US$1 billion US bond issue shall enable them to pursue its strategic objectives. The Group has furthered strengthened its business position through acquisitions and by launching new products in FY20. It has also maintained investment in R&D and introduced several new products, including robotic platform. Overall, the Company has a proven strategy, unique portfolio, and a robust balance sheet to take advantage as market recovers.

However, the business is exposed to several principal risk factors, such as cybersecurity, regulatory changes, failure to launch new products, talent management, pricing and reimbursement, commercial risk, unsuccessful integration of acquired businesses, political and economic factors. Also, the emerging risk of Covid-19 has been affecting the business continuity and causing a substantial amount of financial risk. 

Industry Outlook Dynamics

The Global medical device market is expected to reach over US$612 billion by 2025 from around US$424 billion in 2018, accelerating at a CAGR of 5.4 per cent (as per the Fortune Business Insight report). The Global demand is driven by changing lifestyle and health conditions, increasing life expectancy and requirement for innovative medical solutions.

The US market is expected to reach US$300 billion in annual sales by 2030. Moreover, China and India’s markets have the potential to reach over US$200 million and US$40 million, respectively by 2030, since diabetic patients are rising at an alarming rate. However, the industry also faces several pressures such as complex regulatory procedure, geopolitical factors, and competition.

(Source: Presentation, Company Website)

After understanding the industry dynamics, we will analyse some key fundamental and shareholders statistics of Smith & Nephew Plc.

Recent Developments

On 06 January 2021: The Company confirmed that Vinita Bali had retired from the position of Non-Executive Director on 31 December 2020 after completing six years of service.

On 04 January 2021: The Company updated that it had completed the acquisition of the Extremity Orthopaedics business of Integra Life Sciences Holdings Corporation for USD 240 million.

A Glimpse of Business Segments (FY19 Revenue Split)

Q4 FY20 and FY20 Trading Update (as on 11 January 2021)

• The Company had anticipated a decline of 7% in Q4 FY20 revenue compared to an equivalent period of the prior year due to the Covid-19 restrictions in the U.S. and Europe.
• The business performance remained resilient in Advanced Wound Management and Trauma division.
• The Orthopaedic Reconstruction, Sports Medicine and ENT businesses were adversely impacted by Covid-19 pandemic during Q4 FY20.
• The full-year FY20 underlying revenue was expected to decline by 12%, while the trading profit margin was also dropped year-on-year due to lower volumes.
• The Company was engaged in developing new products and making key acquisitions throughout 2020.

Financial and Operational Highlights (for the six months ended 27 June 2020 (H1 FY20), as on 29 July 2020)

(Source: Company result)

• The H1 FY20 business performance was impacted by Covid-19 related restrictions.
• The Company had shown decent recovery in Q2 FY20 after the resumption of elective surgeries division. The elective surgeries had restarted across the U.S. and most of the European nations.
• The Company had reported 18.1% decline in revenue from USD 2,485 million during H1 FY19 to USD 2,035 million for H1 FY20.
• The revenue decline during Q2 FY20 was marginally improved with an underlying revenue decline of -47% in April 2020, -27% in May 2020 and -12% in June 2020 compared to the similar period of the prior year.
• The operating/trading loss was negative USD 5 million during H1 FY20.
• The Company had delivered discretionary cost saving of around USD 150 million during H1 FY20.
• The Company had highlighted the strong performance of newly launched products such as OR3O^◊Dual Mobility Hip System and EVOS^◊ in Trauma.
• On the leverage front, the Company had a net debt of USD 2.10 billion as of 27 June 2020. The increase in debt was due to dividend payments, acquisitions, and unfavourable movement in the working capital.
• Based on its healthy financial position, the Company had paid an interim dividend of 14.40 US cents per share on 28 August 2020.
• The Company had generated USD 125 million cash flow from the operating activities during H1 FY20, while it was USD 543 million for H1 FY19.
• The Company had sufficient liquidity reflected by committed banking facilities of USD 3.40 billion as of 27 June 2020.

Financial Ratios

 Share Price Performance Analysis

On 28 January 2021 (before the market close, at 9:25 AM GMT), SN.’s shares were trading at GBX 1,559.00, down by 3.35% against the previous day closing price. Stock 52-week High and Low were 2,023.00 and GBX 1,055.01, respectively.

From the technical standpoint, 100-day SMA (1,514.30), and 100-day EMA (1,540.6) are currently supporting an upside potential, which means the stock price could increase in the short term.

In the past two years, SN.’s share price has delivered a positive ~14.76% return as compared to a negative ~2.66% return of FTSE 100 index, and a positive ~3.96% return of FTSE All Share Health Care Equipment & Services index, which shows that the stock has outperformed the benchmark index and the sector.

Valuation Methodology: Price/Earnings Approach (NTM) (Illustrative)

Business Outlook Scenario

The Company has shown encouraging signs of activity rebuilding in the core markets, and it will also take advantage when markets recover. Further, the Company’s current ratio is higher than the industry, which shows SN has enough cash to recover the short-term obligations. In the medium term, the Group looks forward to improving trading profit margin with a proven strategy to outgrow the markets. Further, the progressive dividend policy underpins confidence in the outlook, while the Group intends to return to dividend growth when the performance allows. The Company is quite optimistic regarding the elective surgery division as it had shown significant improvement in its business performance driven by decent growth in the two largest markets, U.S., and China. The Company had launched multiple innovative products and completed the acquisition of Extremity Orthopaedics business of Integra Life Sciences Holdings Corporation on 04 January 2021, which would make significant contributions in the revenue of the Company. The Company had anticipated a decline in FY20 top-line and bottom-line business largely due to an adverse impact of Covid-19 restrictions throughout the year. The Company remained confident regarding the medium-term growth prospects due to its robust balance sheet, effective strategic team, and strong management team.

(Source: Company presentation)

Considering the improved financial performance during H2 FY20, decent cash generation capabilities, multiple innovative products, solid balance sheet, and support from the valuation as done using the above method, we have given a “BUY” recommendation on Smith & Nephew Plc at the current market price of GBX 1,559.00 (as on 28 January 2021, before the market close at 09:25 AM GMT) with lower double-digit upside potential based on 27.11x Price/NTM Earnings (approx.) on FY21E earnings per share (approx.). 

*All forecasted figures and Peer information have been taken from Refinitiv, Thomson Reuters.

*Dividend Yield may vary as per the stock price movement.

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