Smith & Nephew Seeks to Expand Presence in ASCs; Modestly Lowering Our Fair Value Estimate

Business Strategy & Outlook

Impressive innovation has allowed Smith & Nephew to carve out a slice of the orthopedic, sports medicine, and wound-care markets. Though the company is smaller than the dominant orthopedic competitors, it has punched above its weight in terms of introducing meaningful innovation with its pioneering hip resurfacing implant and knee replacements with Verilast technology, which it contends can last for 30 years. These are significant improvements that exceed the evolutionary innovation typically seen in orthopedics.

Nevertheless, as the competitive set consolidates, Smith & Nephew’s position as a midsize competitor leaves it vulnerable as the hospital customer base seeks to reduce vendors to save costs. The firm’s market share–about 10% of hips and knees–translates into a tenuous position. Share shifts in this market are glacial at best, thanks to significant switching costs, and new technology does not necessarily overcome those switching costs. Smith & Nephew’s strong show of meaningful innovation translated into a mere 200-basis-point gain in share over the past decade. This showdown between technical innovation and the stickiness of surgeon preference underscores how difficult it is to induce practitioners to switch. This dynamic and Smith & Nephew’s smaller user base mean the firm could find itself locked out of more hospitals and healthcare systems in the future.

The firm has been aggressively pivoting to reduce its reliance on large-joint replacement with the acquisition of ArthroCare for its arthroscopy and sports medicine presence, concerted efforts to penetrate emerging markets, and the new additions of Osiris Therapeutics for its regenerative products and Leaf Healthcare’s pressure sore-monitoring system. The jury is still out on whether this is enough to allow Smith & Nephew to compete effectively against competitors that continue to grow larger and remain independent. As the market moves gradually toward more vendor consolidation, Smith & Nephew eventually pair up with a larger rival, such as Stryker or Johnson & Johnson, in order to better compete.

Financial Strengths

Thus far, the little to make us nervous about Smith & Nephew’s financial flexibility. While the firm has periodically made acquisitions, it has also generated enough cash to deleverage in relatively quick fashion. For example, following the acquisitions of Osiris in 2019, debt/EBITDA rose to just over 4 times, but has moderated since then. Smith & Nephew can easily meet its interest obligations many times over. Prior to the pandemic, the firm consistently held net debt/EBITDA around 1 time. As with other med tech firms, Smith & Nephew issued debt in 2020 to enhance its cash cushion in the face of uncertainty. With procedure volume resuming, the firm to end the year with net debt/EBITDA around 2.3 times and for further deleveraging in the ensuing years. This still leaves plenty of flexibility for management to leverage up, if management decides to further round out Smith & Nephew’s portfolio in adjacent areas to its core markets. At this point, the firm can fund ongoing operations and support its intention to make regular share repurchases with its cash flow, but it may use debt financing for more large acquisitions.

Bulls Say

Smith & Nephew participates in the fast-growing sports medicine arena thanks to its extensive arthroscopy portfolio.

A strong arthroscopy presence in ambulatory surgical centers leaves Smith & Nephew well positioned to expand its large joint footprint in that setting.

Smith & Nephew has been building out its presence in emerging markets. Considering the obstacles in developed markets that keep it from transforming into a top-tier player, S&N may enjoy greater upside in developing markets.

Company Description

Smith & Nephew designs, manufactures, and markets orthopedic devices, sports medicine and arthroscopic technologies, and wound-care solutions. Roughly 42% of the U.K.-based firm’s revenue comes from orthopedic products, and another 30% is sports medicine and ENT. The remaining 28% of revenue is from the advanced wound therapy segment. Roughly half of Smith & Nephew’s total revenue comes from the United States, just over 30% is from other developed markets, and emerging markets account for the remainder.

(Source: Morningstar)

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