Oh dear. Just when it seemed like Smith & Nephew was making progress, the FTSE 100 company has dished out another profits warning.
As a result, shares in the orthopaedics, wound care and sports medicine specialist are limping lower once more, to leave us with a growing paper loss relative to our tip in March last year and in a quandary, because it is tempting to just give up on the stock after the latest stumble.
However, Smith & Nephew’s competitive position is strong, some of its problems look temporary and an action plan is in place to tackle the underperformance at orthopaedics, so we will stick with the shares for now.
Our thesis remains that Smith & Nephew should see increased levels of business as Covid‑19 retreats into the history books and the volume of elective surgical procedures recovers as a result, to the benefit of the hip and knee implant business in particular.
The other two legs of the company, Sports Medicine and Advanced Wound Management, both offer long-term growth potential that can complement any upturn in orthopaedics. The first half of 2022 showed underlying revenue growth of 3.5pc and that was a start. Unfortunately, the strong dollar wiped it all out, so on a stated basis revenues came in flat for the first six months of the year.
At least the chief executive, Dr Deepak Nath, stuck to the company’s guidance for underlying sales growth of 4pc to 5pc. However, he then warned that profit margins would undershoot expectations and fall to 17.5pc from last year’s 18pc.
Management had originally targeted a figure of 18.5pc this year. Nath cited the dollar, lockdowns in China and supply chain challenges as contributory factors and frankly this column is prepared to forgive all three of those. The boss also noted input cost inflation, which must be watched.
Of greatest concern is his comment about poor execution at the orthopaedics unit, which still generates a good 40pc of group revenues. This, therefore, raises questions about whether management is dropping the ball. Given that Nath took the helm only on April 1, that would be a harsh judgment, but it is now his job to get orthopaedics back on track.
A review of the business and a productivity plan are in place. It is also encouraging to see the chief executive emphasise how Smith & Nephew continues to invest in research and development for the long term, as the temptation to cut short‑term costs in search of a quick win must be strong, even if the impact of such a decision on the business could be deleterious further down the road.
An unchanged interim dividend of 14.4 US cents a share speaks of some confidence in the future and follows on from February’s declaration of a flat full-year payment of 37.5 cents for 2021. Enhanced cash returns remain on management’s agenda and Smith & Nephew is running a share buyback scheme too.
The company has not run many of these – the last buyback of any size came in 2016 – although it is hard to avoid the conclusion that this has yet to prove an effective way to allocate precious capital this time around. The $125m (£105m) spent on share buybacks in the first half of the year provided no support to the share price. The scheme has another $125m to go in the second half of this year.
The shares continue to trade at a discount to comparable American companies such as Stryker and Zimmer Biomet. At the moment, it is admittedly hard to avoid the conclusion that they deserve to do so.
But if orthopaedics gets up and running again and the productivity plans start to drive profit margins higher, earnings estimates could start to rise, not fall, and that could prompt investors to close the valuation gap.
Since the share price is, crudely, a function of valuation times earnings (as per the p/e ratio), a rise in both at the same time would provide a powerful gearing effect.
We’ll stick with Smith & Nephew. For now.
Questor says: hold
Share price at close: £10.86
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