Robotic portfolio support

Smith & Nephew doesn’t only provide support to patients needing hip and knee replacements. It also offers

investors with invaluable portfolio support with the shares only seeing a 39% peak to trough drop in the financial

crisis. Full year results for 2015 were sound and with an attractive valuation our rating is buy.

The ongoing global equity market weakness has seen the FTSE 100 fall by over 20% from its peak at one point

last week. However, if you were only holding certain defensive stocks you wouldn’t be aware that there had

been a correction.

Unilever saw its share price hit an all-time high of £30.85 at the end of January and Reckitt Benckiser is trading

at around its all-time high of £64. National Grid saw its shares hit a new high of £9.90 in early February.

The message is that the correction has to date been sector driven with resources, biotech, technology and

banks all seeing weakness. Companies that have continued to deliver have been rewarded for doing so.

Smith & Nephew’s long-term pedigree: founded in the UK in 1856

Source – Smith & Nephew annual report

Smith & Nephew is the UK’s largest medical equipment company and is exposed to resilient demand. The

company has been seen as a takeover target for years and there is a reasonable chance of a formal offer in the

medium-term.

The fundamentals for Smith & Nephew remain sound with underlying revenue up by 4% in 2015 and underlying

trading profit up by 5%. The group also resumed its share buy back programme after announcing full year

results.

Smith & Nephew in 2015: by product and revenue

Source: Smith & Nephew

We view the valuation as attractive with the forecast P/E for 201 at 18.8X and falling to 16.8X for 2017. Looking

further out and the forecast P/E falls to around 10.2X for the year to 2020 while the dividend yield is forecast at

4.6%.

Turning to the charts, the shorter-term price chart appears volatile. Prices are currently respecting resistance at

1149p, being the 61.8% Fibonacci retracement (measured from the December 2015 high of 1217p down to the

9th February low of 1040p). A sustained break above this level would be bullish, and shall open up the next

target levels towards 1179p, followed by a re-test of the previous high of 1217p.

With reference to the weekly chart, the long-term uptrend remains firmly in place. However, and for the best part

of 2015 to-date, prices have been largely contained within a broad consolidation between support at 1040p and

resistance at 1217p. A decisive break above the upper boundary is likely to trigger the return of share price

momentum and lead to a new leg higher over the broader term.

Smith & Nephew’s strategy: shift to higher growth markets

As a reminder the strategy of Smith & Nephew is to move into higher revenue growth markets. These include

Sports Medicine Joint Repair, ArthoCare, Trauma & Externalities, Gynaecology and lastly Advanced Wound

Bioactives and Devices.

Emerging markets are considered to be a higher growth area across all product franchises. Lower growth areas

include Arthroscopic Enabling Technologies, Reconstruction and Advanced Wound Care.

As the shift towards faster growing markets continues the overall pace of revenue growth at Smith & Nephew will

improve. It is notable, for example, that emerging markets are still only a small part of group revenue at 15% in

2015.

Smith & Nephew’s plan

Source: Smith & Nephew investor presentation

Emerging market (EM) focus: accelerating EM development

Source: Smith & Nephew investor presentation

In the first half of 2014 the group generated half of total revenue from higher growth markets. It will therefore not

be too much of a stretch to hit the target for 67% of revenue to come from higher growth markets.

Underlying growth drivers for the business will also help to support the rate of revenue expansion. These

include the ageing global population with the number of people aged over 65 on track to triple by 2050.

Other drivers include new technology, more active lifestyles, rising income per head in emerging markets and

the prevalence of medical conditions (i.e. obesity and diabetes). Even without the shift to higher growth markets

Smith & Nephew is well placed.

A challenge continues to be the ability to pay in established markets due to austerity measures and rising

healthcare costs. In emerging markets the group is offering mid-tier models due to the lower incomes per capita.

Source: Smith & Nephew investor presentation

Smith & Nephew is the second largest player in Advanced Wound management by market share. It is also the

second largest player in Sports Medicine while in Hip & Knee Implants it is the fourth largest player.

Smith & Nephew’s market position

Source: Smith & Nephew investor presentation

Recent updates: going robotic

We last reviewed Smith & Nephew on 1st October 2015 (FAT UK 605) and rated the stock as a buy at

£11.50. The group has paid a 7.68p dividend since then and currently trades at around £11.10.

This shows an impressive resilience in the face of the market correction and economic instability in emerging

markets. CEO Olivier Bohuon was revealed to have been diagnosed with a “highly treatable form of cancer” in

early February.

He will remain as CEO and will continue running the company when treatment starts at the end of this month. It

will include chemotherapy and is set to be completed by late autumn.

At the start of January Smith & Nephew announced the acquisition of Blue Belt Holdings. The company is

described as having a “leading position in the fast-growing area of orthopaedic robotics-assisted surgery.”

Blue Belt’s Navio surgical system & Navio assisted partial Knee replacements

Source: Smith & Nephew

Blue Belt provides robotics-assistance for knee replacement and so is in an area that Smith & Nephew is familiar

with. Smith & Nephew’s partial knee implant portfolio will form a combined business with Blue Belt’s Navio

surgical system.

Further upside is expected to be achieved by expanding the Navio system to total knee, bi-cruciate retaining

knee and revision knee implants. The deal helps push Smith & Nephew into technology-led and higher growth

areas.

Blue Belt Technologies

Source: Smith & Nephew investor presentation

Smith & Nephew: fourth quarter profile

Since we last covered Smith & Nephew the group has reported its third quarter and fourth quarter results. The

fourth quarter gives the most up to date snapshot of how the group generates its revenue.

Around half of the group’s revenue comes from the United States and this market saw 5% underlying revenue

growth in 2015. Emerging markets saw 11% underlying revenue growth in 2015.

Established markets Outside the US (Est OUS) is Australia, Canada, Europe, Japan and New Zealand. This

geographic block only saw 1% underlying revenue growth in 2015.

Fourth quarter profile: geographic and product split

Source: Smith & Nephew investor presentation

Turning to the product breakdown and Smith & Nephew is well diversified with knees and hip replacements only

one part of the business. Advanced Would Management is equally important and is seeing rapid growth.

Advanced Would Management includes Advanced Wound Care (AWC), Advanced Wound Bioatives (AWB) and

Advanced Wound Devices (ADD). These areas saw Q4 annual revenue growth of 4%, 16% and 14%

respectively in 2015.

Smith & Nephew 2015 financial results

Turning to the annual financial results for 2015 and underlying revenue, excluding acquisitions/disposals and FX,

was up by 4%. While Smith & Nephew is not a fast growth business it does see reliable and steady revenue

expansion.

Growth has been supported by acquisitions as if we factor these in revenue increased by 8% in 2015 at constant

exchange rates. The key deal was the purchase of ArthoCare for US$1.5bn on 29 May 2014.

The constant currency trading profit improved by 10% during the year as margins improved. Adjusted earnings

per share (EPSA) saw a 9% improvement on a constant currency basis.

Smith & Nephew financial results in 2015

Source: Smith & Nephew investor presentation

Looking at the reported results and with Smith & Nephew’s reporting currency being the US dollar, currency

headwinds are not surprising. At the same time the group has around half its revenue in the US where it is

currency neutral.

Reported revenue was flat due to an 8% currency headwind but trading profit saw a 4% gain and EPSA

increased by 2% to US$0.851. Clearly the margin improvement managed to offset the currency headwind in

2015.

The group’s trading margin at 23.7% compares to 22.9% in 2014 and looking further back the margin was 22.7%

in 2013. Margin expansion was driven by ArthoCare synergies and “group optimisation.”

Margin expansion drove the 2015 results

Source Smith & Nephew investor presentation

The balance sheet improved in 2015 as free cash flow more than doubled to US$672m from US$308m in

2014. Trading cash flow improved to US$936m from US$781m in 2014.

This helped push net debt down to US$1.36bn at the end of the year versus US$1.61bn at the start of

2015. This compares to net debt of only US$253m at the end of 2013 and reflects the purchase cost of

ArthoCare in 2014.

Smith & Nephew’s balance sheet improved in 2015

Source: Smith & Nephew investor presentation

Smith & Nephew has a solid track record with acquisitions and to date the ArthoCare takeover is going as

planned. Having a greater product line-up to sell to hospitals helps to create revenue and cost synergies.

Smith & Nephew’s recent large deals have paid off

Source: Smith & Nephew investor presentation

Summary and valuation

Smith & Nephew still remains a takeover candidate with possible acquirers being Johnson & Johnson and also

Stryker. This provides potential upside and we know that Stryker previously considered making an offer.

The fundamental investment case also remains sound, in our view, with the pace of revenue growth

improving. In 2014 underlying revenue growth was 2% but in 2015 the pace of top line expansion came in at

4%.

Growth is supported by the ageing global demographic and Smith & Nephew’s shift into higher growth

markets. Margin expansion has also bolstered profits growth with adjusted EPS increasing at 8% a year from

2010 to 2014.

Smith & Nephew’s solid track record: 2010 to 2014

Source: Smith & Nephew investor presentation

The full year dividend was increased by 4% to US$0.308 versus the 2% increase in reported EPSA to

US$0.851. The dividend per share was only $0.158 in 2010 and the company has paid a dividend in every year

since 1937.

Against this track record and business outlook we continue to view the investment case as attractive. Further

acquisitions will bolster earnings with Blue Belt Technologies the latest to join the fold.

Guidance for 2015 is for further revenue growth and margin improvement with both set to drive through an

increase in adjusted earnings per share. The forecast P/E for 2016 is 18.3X with a forecast yield at 2% (2.7X

covered).

The company offers meaningful value further out with a forecast P/E of 16.4X in 2017 and by 2020 the forecast

falls to around 10X. Market drivers, such as demographics and emerging markets, will support long-term

earnings growth.

Accordingly, Smith & Nephew will remain firmly held in the Fat Prophets portfolio. For members without

exposure we recommend the shares as a buy.

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